MRS Katie Esar and MR Reuben Esar v. Her Majesty the Queen, [1974] CTC 34, 74 DTC 6062

Heald, J:—These actions are appeals from the judgment of the Tax Review Board maintaining the assessments issued by the defendant through the Minister of National Revenue in respect of the assessment for income tax of each of the plaintiffs for the 1967, 1968 and 1969 taxation years. Upon the consent of the parties and pursuant to the order of Associate Chief Justice Noël, the actions were heard together on common evidence.

There are two separate and distinct issues involved in these appeals. The first issue relates to the deductibility of regular annual real estate taxes paid by the plaintiffs during the taxation years under review on property known as Lot 335 in the Parish of St Vincent de Paul, a Montreal suburb.

The plaintiffs are husband and wife and were in business together on a fifty-fifty basis. They have been in the mortgage lending business since 1931 dealing mostly in second mortgages. Additionally, however, they have, over the years, acquired other investments. In 1951 they acquired a duplex where they have lived ever since, deriving annual income from the portion thereof not occupied by them.

In 1959 they acquired a 5.55% interest in a large office building in Montreal from which they continue to derive annual income. In 1962 they acquired a one-half interest in an 18-apartment building from which they also obtain annual income. In addition to the above described investments, the plaintiffs have, over the years, also been involved in at least two trading transactions involving purchase and sale of land. One of these transactions involved the purchase and sale over a 2-3-year period of some land in the suburb of La Prairie. Plaintiffs made a profit of some $5,700 on this transaction which they reported as income for the taxation year in question. Plaintiffs were also involved in some land trading transactions in Duvernay over a 4-year period and also reported their profit in the sum of $14,000 on these transactions as taxable income.

Subject parcel of land, Lot 335, St Vincent de Paul, was purchased by the plaintiffs in February of 1955. Mrs Esar testified that she and her husband purchased it as “an investment for income”. She said that their intention, at date of purchase, was to erect thereon a commercial or industrial building (there being no zoning restrictions) which they would lease on a long-term basis, thus deriving income therefrom. She said that she and her husband never intended to live there or to farm nor was the property purchased in any way for personal use or pleasure. It was intended to be used to gain income for the plaintiffs. Subject property has a 477 foot frontage on a main arterial street, the length of the property being traversed by CPR railway tracks. At time of purchase, there was a rather old house and barn on the property. The property’s total area was some 78 arpents and its prior use was as a farm. Plaintiffs rented the house after acquisition in 1955 for approximately $40 per month. By 1960 the house had deteriorated to such an extent that the City advised the plaintiffs that the house was condemned as being unfit for human habitation and ordered its demolition. Pursuant to such order, plaintiffs had the house demolished in 1960 or 1961. Since then, the property has remained vacant. Mrs Esar says they have tried to rent the same as farming land but without success.

During the years when there was rental income from the property, it was reported as income while the property taxes paid on the property were claimed as a deduction from income. After demolition of the house there was no income from the property but the plaintiffs continued to deduct from their other income the amount of property taxes paid on subject property in each year. The issue in this appeal is the propriety of said deductions. The defendant agrees that the plaintiffs acquired subject property as a capital investment but pleads that said capital investment was not acquired for the purpose of gaining income from the property and that, therefore, the real estate taxes paid by plaintiffs are not an expense made or incurred for the purpose of producing income from said property but are rather an outlay on account of capital, and, as such, are not deductible under the provisions of the Income Tax Act. In support of this submission, the defendant first refers to paragraph 12(1 )(a) of the Income Tax Act which reads as follows:

12. (1) In computing income, no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from property or a business of the taxpayer,

The defendant then refers to paragraph 12(1)(h) of the Act and subparagraph 139(1 )(ae)(i) which read as follows:

12. (1) In computing income, no deduction shall be made in respect of

(h) personal or living expenses of the taxpayer except travelling expenses (including the entire amount expended for meals and lodging) incurred by the taxpayer while away from home in the course of carrying on his business,

139. (1) In this Act,

(ae) “personal or living expenses” include

(i) the expenses of properties maintained by any person for the use or benefit of the taxpayer or any person connected with the taxpayer by blood relationship, marriage or adoption, and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit,

By reference to these sections, the defendant submits that when paragraph 12(1)(a) speaks of profit, it must be read with paragraph 12(1 )(h) and subparagraph 139(1 )(ae)(i) and when so read is qualified so as to mean “property acquired with a reasonable expectation of profit”.

Thus, on the facts here, the defendant submits that the plaintiffs have not established that they acquired subject property with a reasonable expectation of profit. Defendant’s counsel points to the fact that the property has been held a number of years without income, that even when there was income it was comparatively small compared to the cost of the property (the property was acquired at a cost of $20,000 while the annual gross rental derived therefrom from 1955 to 1960 was in the order of $500). He also emphasizes the fact that the plaintiffs have done absolutely nothing in the years since acquisition in 1955 to develop the property in any way, nor are there any plans in process of formulation for subject property, even at the present time. Defendant’s counsel is really asking me to find that the objective facts and circumstances in this case negative the expressed intentions of the plaintiffs as represented by the sworn testimony of Mrs Esar. With every deference, I do not agree that the objective facts present in this case do so negative Mrs Esar’s sworn testimony. Mrs Esar says they bought the property to build thereon a commercial building for lease for income. The evidence was that they had so conducted themselves on earlier occasions by acquiring investment properties and retaining them. In this case, they have retained subject property, even up to the present time. They have never made any attempt to sell the land nor has it ever been listed for sale with any real estate firm. Mrs Esar says that she and her husband have retained their intention to build for investment income on this site. The Esars are not wealthy people, their annual net income over the years, since 1961, has fluctuated from $4,000 to $9,000 for each of them. Their financial circumstances are such that they would not be able to finance a commercial building on subject property immediately after acquisition thereof. I attach no significance to the fact that no building was commenced prior to the years under review. I think the plaintiffs’ plans for this property were, of necessity, in their financial circumstances, long-range plans, but realistic, nevertheless, in view of their proven ability in the past to invest successfully in revenue-producing properties. Nor is it fatal to the plaintiffs’ claim for deductibility that the subject tax expenditures did not result in the production of income. In the case of Consolidated Textiles Limited v MNR, [1947] CTC 63 at 68; 3 DTC 958, President Thorson said:

It is not a condition of the deductibility of a disbursement or expense that it should result in any particular income or that any income should be traceable to it. It is never necessary to show a causal connection between an expenditure and a receipt.

In summary, it is my opinion that the objective facts and circumstances of this case, when considered in their true light, corroborate, rather than negate, the sworn testimony of Mrs Esar. So far as the testimony of Mrs Esar was concerned, I found her to be a credible witness, very straightforward and frank in her answers and I accept her testimony in its entirety. Additionally, it should be noted that the defendant adduced no evidence so that the only direct evidence of the plaintiffs’ intentions was the evidence of Mrs Esar.

In view of the foregoing facts, I have concluded that the plaintiffs have discharged the onus cast upon them of establishing that subject land was retained in the reasonable expectation that they would be able to utilize the land for the construction of a commercial or industrial building which they would rent out for income. That being so, it follows that the payment of property taxes was an expenditure on revenue account and as such was laid out for the purpose of gaining or producing income within the meaning of paragraph 12(1)(a) of the Kugler was in the home-building business at the time and was engaged in the construction of single-family homes on Lot 350 which adjoined Lot 351. Mrs Esar says that the partners purchased Lot 351 intending to make a quick profit either by reselling the property at an early date or by constructing and selling homes. Full title to the property was originally taken in the name of Max Esar who, in April of 1961, transferred to the plaintiffs the undivided V* interest to which they were entitled. On December 29, 1961 the partners sold subject property to Bonjour Investment Corporation (hereafter Bonjour), a Quebec corporation, for the sum of $160,000, whereof only $400 was paid as a downpayment. Bonjour was beneficially owned by the same parties and in the same proportions, that is, Max Esar—50%, Julius Kugler—25% and the plaintiffs—25%. Also, on December 29, 1961 Bonjour sold a portion of subject property (some 49 lots out of a plan of subdivision which had been registered by the partners with the object in mind of either selling lots or building homes and selling the homes) to Eliteville Development Corporation (hereafter Eliteville).

Said 49 lots were sold to Eliteville for a price of $1,000 per lot, a total of $49,000. Eliteville was wholly owned by Kugler, the plaintiffs having no interest in same. Bonjour received only a $500 deposit on account of said purchase price.

Kugler began to build homes for sale on subject property but was only able to complete nine homes. He soon ran into financial difficulties. He incurred substantial liabilities with the municipal authorities through the cost of sewer, water, light, sidewalks and streets, etc. There was also a change in the interest rates and the lending policies of Central Mortgage and Housing Corporation which caused problems for him. The result was that he was obliged to stop the development of the subdivision, being on the verge of bankruptcy. The 40 undeveloped lots were returned to Bonjour. Bonjour made a number of unsuccessful attempts to dispose of the property elsewhere. In 1966 they optioned 113 lots to another house-building firm but this firm only exercised the option in respect of two lots before allowing said option to expire. The municipal authorities sued Bonjour for some $50,000 for unpaid taxes and services. Thus, Bonjour’s position in respect of this property, as of January 1963, was that it had some vacant land which it could not sell or develop; it was in debt to a considerable extent and was, for all practical purposes, bankrupt. Mrs Esar testified that the partners concluded that there was no alternative but to attempt to find someone who would take the property over for what was owing against it. They were successful in finding such a party. By an agreement dated January 22, 1968 all the shares of Bonjour were sold and transferred to one Peter Vineberg, et al. By an agreement dated January 24, 1968 the various shareholders of Bonjour transferred their accounts receivable from Bonjour in the sum of $159,600 (being the total purchase price of the land less the down-payment of $400) to the said Peter Vineberg in trust. The purchaser assumed the debts of Bonjour.

None of Bonjour’s shareholders received any cash consideration. This transaction was an arm’s length transaction, the purchasers being unknown to the vendors.

Thus the position of the plaintiffs was that they had originally paid $20,000 for their interest in this land. They actually only received $100 therefrom (their 25% share of the $400 down-payment). Then, in January of 1968, they were forced, through circumstances, to give up any interest they had in the property or the proceeds thereof without receiving any additional compensation. In summary, they invested $20,000 in 1955, they received $100 in 1961 and they lost the balance of their investment in the sum of $19,900 in 1968. Mrs Esar said that they had no choice but to take their loss. She felt that at least she and her husband had saved their reputation and good name from the stigma of being associated with a bankrupt company.

The plaintiffs took the position that said loss in the sum of $19,900 was a loss arising from a venture in the nature of trade in the acquisition of land with the intention of selling it at a profit and claimed said loss as an expense in filing its income tax return for 1968. The defendant disallowed this item of expense and the propriety of said disallowance is the issue in this portion of the plaintiffs’ appeal.

The defendant takes the position that the plaintiffs sold their interest in subject property in 1961 at a profit of $20,000 (see paragraph 21 of statement of defence); that, since the plaintiffs had not included said profit of $20,000 in their income for 1968 or any previous year, then they were not entitled to claim the sum of $19,900 as a deduction and the defendant relies on the provisions of paragraph 11(1)(f) of the Income Tax Act.* [1]

In essence, the defendant is attempting to argue that the plaintiffs, in reality, should have been filing their tax returns on an accrual basis, that on said basis, they realized a profit on this transaction in 1961 of $20,000, that their only right to claim a bad debt exists if they can bring themselves within the provisions of said paragraph 11(1 )(f) which they cannot do because they did not show their $20,000 profit as income.

It should be noted that all through the years, inclusive of 1961, plaintiffs filed their tax returns on a cash basis without any request from the income tax Department to file on an accrual basis. Throughout the years the plaintiffs’ returns were prepared by a firm of Montreal chartered accountants, Messrs Mallette, Cote, Normandin & Company. Considering the rather modest nature of plaintiffs’ business operations, the returns seem to be very complete possessing much more. detailed information than is often the case. Subject returns contain the following supplemental statements:

(a) net income statement for the various properties;

(b) statement of dividends;

(c) balance sheet; and

(d) statement of profit and loss.

In my view, subject returns provide an accurate and detailed picture of all of the plaintiffs’ business operations. They were prepared by a reputable firm of chartered accountants who obviously considered the cash basis of income reporting to be the proper basis for these plaintiffs. The income tax Department most certainly agreed because they accepted the 1961 and subsequent returns on a cash basis and assessed on a cash basis. In my view, plaintiffs acted quite properly in 1961 in not reporting a “paper profit” which eventually turned out to be a loss.

Plaintiffs were clearly covered by the provisions of paragraph 85B(1)(b) of the Act* [2] wherein cash taxpayers are exempted from including future accounts receivable in income.

I have no hesitation in concluding on the evidence in this case that the cash basis for reporting income was the proper basis for these plaintiffs in accordance with recognized accounting principles. As was stated by President Thorson in the case of MNR v Publishers Guild of Canada Limited, [1957] CTC 1 at 17; 57 DTC 1017 at 1026, the Court must keep a watchful eye on arbitrary assumptions by the taxing authorities that they are entitled to conclusively refuse or permit any particular system of accounting. The learned President goes on to say:

. . . I cannot express too strongly the opinion of this Court that, in the absence of statutory provision to the contrary, the validity of any particular system of accounting does not depend on whether the Department of National Revenue permits or refuses its use. What the Court is concerned with is the ascertainment of the taxpayer’s income tax liability. Thus the prime consideration, where there is a dispute about a system of accounting is, in the first place, whether it is appropriate to the business to which it is applied and tells the truth about the taxpayer’s income position and, if that condition is satisfied, whether there is any prohibition in the governing income tax law against its use. . . .

In the case at bar, the plaintiffs had a paper profit of $20,000 in 1961 which developed into an actual loss of $19,900 in 1968. To require these plaintiffs to pay income tax on a profit which they never received in view of the subsequent loss of their entire investment would be truly to add “insult” to “injury” and any system of accounting which would permit such a result is clearly not appropriate to the plaintiffs’ business and certainly would not be telling the truth about the taxpayers’ position in this case.

I have also satisfied myself that there are no prohibitions in the governing Income Tax Act which would prevent these plaintiffs from filing on a cash basis during the years under review.

Defendant’s counsel submitted, alternatively, that subject transaction was not essentially a trading transaction but was rather a capital transaction and, as such, any loss resulting therefrom was a capital loss and therefore not deductible under paragraph 12(1)(b) of the Income Tax Act. In support of this submission, counsel points to the plaintiffs’ 1968 income tax return where, in the statement of earnings, the said loss of $19,900 is characterized as “Loss on surrender of real estate investments”. I do not attach any significance to this terminology. What the Court has to consider is the true nature of the transaction. On the evidence before me, I conclude that subject transaction was truly a trading transaction. Confirmatory of this conclusion is the sworn testimony of Mrs Esar, which testimony I believe. Mrs Esar’s testimony is confirmed by the objective facts. In furtherance of their trading intention, the partners subdivided subject property for a single-family housing subdivision, they installed the necessary services and did in fact commence to resell the property with constructed houses on it. Since subject transaction was a trading transaction, plaintiffs’ loss was an outlay incurred for the purpose of gaining income from their business within the extended meaning of “business” as contained in paragraph 139(1 )(e) of the Act. It follows that said loss was properly chargeable against income In the year in which it was incurred, namely 1968.

The appeals will therefore be allowed in respect of both of the items in issue. The assessments of both plaintiffs for the 1967, 1968 and 1969 taxation years are referred back to the Minister for reassessment not inconsistent with these reasons. The plaintiffs are entitled to one set of costs against the defendant since both appeals were heard together on common evidence.