Fredericton Housing Limited v. Minister of National Revenue, [1972] CTC 2549, 72 DTC 1458

The Chairman (orally):—This is an appeal by Fredericton Housing Limited, a company incorporated under the laws of the Province of New Brunswick, against a reassessment of the Minister for the taxation year 1970.

The case falls into the usual class of cases known as “trading” cases and arises out of the fact that the Minister of National Revenue has added back to income for the taxation year in question a profit made on the sale of a parcel of land in the City of Fredericton which the appellant company has treated as capital gain and which the Minister has treated as income.

There has been placed in evidence on behalf of the appellant his Exhibit A-1, which is a map of the City of Fredericton and vicinity, including the village of Nashwaaksis. On the map, an “X” has been marked to indicate a subdivision known as “The Skyline” and the area in question has been shaded in ink.

Briefly, the facts are that, according to the testimony of one Joseph W Gorham, he and a Mr John Bird, who were friends, joined together in 1954 to form the appellant company for the purpose of constructing low-cost homes in and about the City of Fredericton. Apparently Bird had sold real estate and had been in the insurance business. He convinced Gorham that if he had someone to build low-cost homes there was a market for same. Gorham at that time was a bottler of a well- known soft drink, and does not appear to have had any great experience at that time in the field upon which he was to embark.

In any event, the two friends incorporated the appellant company, and there were only the two beneficial shareholders, with their accountant as the qualifying third shareholder. However, Bird and Gorham were the beneficial owners of all the issued shares of the company.

As Gorham said, one of the essential ingredients of low-cost home building was low-cost land. They made their first agreement to acquire land with a man by the name of Pugh in the Village of Nashwaaksis, just across the Saint John River from the City of Fredericton. They were able to do so on the basis of an option whereby they would take as many lots as they could during the year, construct and sell homes and then take up more lots. This was the general course that they again followed with some land apparently purchased from a man by the name of Tims or a family by the name of Tims. Other parcels of land were purchased on a less informal basis by way of deed and mortgage back, with the provision in the mortgage for the partial release of lots for specifed amounts as lots were subdivided. Apparently, at the time, there was very little of this type of construction going on in the area, and they were able to obtain the land in this fashion.

They continued to build houses, and for all intents and purposes they were still continuing to build houses in the area at the time of the reassessment.

In 1966 there arose an opportunity to purchase for $65,000 a piece of land (which is shaded in ink on appellant’s Exhibit A-1 and was part of an overall parcel containing 130 acres which is outlined in pencil on the same exhibit) from the Fraser Companies Limited. I am told in the evidence of Mr Gorham that the Fraser Companies had been engaged in business in the Fredericton area for a long period of time and had been in the lumber and pulp and paper business. The land in question was rocky, save and except for a portion towards the highway which was cleared. There had been at one time a quarry on the property, and there was also a brook on it. At the material time there were no services near it. Mr Gorham felt that this was a chance to purchase some land as a long-term proposition. The opportunity apparently would not have arisen if the Fraser Companies had not intended to leave the area.

In any event, the appellant had to purchase it, unlike the other pieces of land already purchased, by making a substantial cash-down payment of $25,000, with a mortgage back of $40,000, some $30,000 of which, with interest at 7%, had to be repaid within 18 months. They did not have the money to pay cash for the land at $65,000 nor did they have the money to pay off the mortgage when it fell due, and they had to obtain an extension, as shown in appellant’s Exhibit A-4. They still were not able to pay off and discharge the mortgage when it fell due under the extension, but they did finally pay for it in, I believe, the year 1969.

The evidence indicates that over the course of the years from 1954 on, the appellant company has been the largest home builder, certainly of the type of homes in question, in the Fredericton area, having constructed some 1,500 or 1,600 homes during the course of that period.

The appellant engaged strictly in house building, and had acquired, shortly after its incorporation, the services of Mr Jack Graham, who had, according to his evidence, started off as a bookkeeper some few months after the incorporation and had worked himself up through administration, helping with the financial end of the business, with Mr Bird as a sort of general supervisor and person who could fill in where required.

His evidence was that the entire business of the company, from the incorporation up until 1969 and 1970, was the construction of houses, and that the company had never been a real estate dealer, nor did he or the company hold a real estate licence.

At about the material time, 1969, Mr Gorham and Mr Bird were apparently both close to 60 years of age, one slightly over and one slightly under, as I recall, and apparently decided that they would like to retire or get out of the business in favour of their sons.

According to his evidence, and also that of other witnesses, the witness Robert Bird, the son of one of the founders of the company, was a Civil engineer and a university graduate who had acquired considerable experience in heavy construction with Diamond Construction Company, which is apparently a very large corporate entity dealing in heavy construction in the Atlantic Provinces. He was approached on the subject of returning to Fredericton to work with the company with the idea of eventually taking over his father’s half interest. He says, and one can accept it from observing him in the witness box, that he was not content to come back if the company was going to remain in housing construction only, but was only interested if it was going to diversify into heavier or larger projects in addition to the housebuilding that it was carrying on. There is evidence that it had done some small jobs other than house construction, but they were, so far as Mr Bird was concerned, too small to be considered a diversification of the nature he was interested in. He was asked ‘“to come back and give it a try” and, if he was satisfied the company was proceeding along the lines he envisaged, he would stay.

lt was his evidence, and uncontradicted, that his position with his present employers was such that he would be able to return to them if he were not content with his move to the appellant company.

A sale took place eventually. The shares were valued by a presumably independent accounting source on a book value basis and also on a “five times earnings” basis The figures came out to approximately the same amount, and the shares were sold. I think the figure of $240,000 or $242,000 was mentioned in the evidence or in argument as being the price at which the founders of the company relinquished their shares.

There is no question in this appeal as to the correctness of such evaluation, and for the purpose of this appeal I simply admit it to be a fair and reasonable price.

However, instead of young Mr Bird and young Mr Gorham taking the 50% each that they were entitled to, they desired to keep Mr Graham and a Mr Thomas in the business and allocated to each of these persons a 10% interest in the company.

The first problem that faced the new owners in their attempt to diversify was that they were unable to acquire in sufficient amounts bonds to support bids, and subsequently, where bids were successful, performance bonds for the carrying out of the operation. The reason for this was very simply that the working capital was not sufficient to meet the requirements of the bonding company.

Evidence was given by Mr David Wilson, who was also a graduate engineer and a master of business administration from the University of Western Ontario. He had been with W Hedley Wilson, his father, in the general insurance field and at the material time was — or perhaps not then but certainly is now — the head of the firm. He had known Robert Bird for some ten years when the latter was with Diamond Construction and, being an aggressive businessman, he was interested in getting the appellant company’s business. If Robert Bird was returning to the company, he felt that his association with him would give him an “‘in’’, so to speak. Eventually this was borne out, and the appellant company switched its insurance to Mr Wilson.

He knew that Mr Robert Bird’s qualifications would be sufficient to bring the appellant company into the heavy construction field, but he also knew that to succeed in this field the company would have to have the bonds that I have already mentioned.

The facts are clear that several jobs were just not available. In fact, the new owners were unable to bid for them, according to Mr Bird’s evidence, because they could not get a high enough bid bond to substantiate their tender. They did in the next year receive denials of bonds on a small job, but were able to get two jobs in Bathurst where no bond was required, a certified cheque being acceptable in lieu thereof. They were able to get one job by hiring a subcontractor for a river crossing who was able to get his own performance bond, and this allowed the appellant company to get the contract.

The evidence is that none of these people were engaged in real estate speculation. That is unquestioned. And it was also clear, on the evidence, that the only way they were going to diversify to the extent that Mr Bird envisaged was to increase the working capital to meet the formula of the bonding companies so that they could bid.

The first step that was taken was that they “spun off’’, as the term is, to a newly incorporated company called Fredericton Housing and Construction Company Limited the current assets and current liabilities so that the picture to the bonding company was more acceptable. This was done on the advice of their solicitors, their accountant and also their insurance agent. They were also able to get a substantial increase in their bonding limits, but again not sufficent to meet the requirements of large-scale bidding.

The evidence is that the Fraser lands were never advertised for sale, and as a result of a conversation with the president of New Brunswick Housing Limited in his office, where Mr Bird was discussing with him the question of housing and construction in general in the area, the president of New Brunswick Housing asked if the appellant company would be prepared to sell any or all of the Fraser Companies property, and offered a price of $2,500 an acre. Mr Bird thought he countered by saying, “How about $3,500?” but, in essence I think, to paraphrase his evidence, he could hardly contain himself at the thought of such an offer for the property.

The evidence substantiates the fact that this was a — I hesitate to use the term “ridiculous”, but at least an extremely high, price for the land in question compared to general land sales in the area.

It is to be noted that Bird did not immediately accept but returned to discuss it with his fellow shareholders, and only Graham, who was primarily concerned with housing construction, raised the question about whether or not they should part with the land, because they needed land for further housing construction.

In any event, they agreed to sell, and did sell, some 80 acres of the 130-acre parcel to the New Brunswick Housing Corporation for a considerable profit.

The evidence of Mr Gorham is that he never dreamed that this land would ever sell for such a price and he said that he might have had second thoughts about selling, or he even went so far as to say he would never have sold, his shares at the price he did had he known that this land could have been sold for the price that it was.

Therein lies the problem in this case. Was this the realization of a capital asset, as the appellant company contends, or was it simply the realization of inventory and thereby income, as the Minister contends? As put very simply by the Minister’s representative, it is merely a difference of opinion, but, however, one which is hard to rationalize and to decide which opinion should be followed.

There is no question whatsoever that the sale at the time that it occurred was a very fortuitous event as far as this appellant company is concerned. It could not continue in the direction in which the diversification was intended without more working capital. It has been pointed out by the Minister’s representative in cross-examination that there are many ways to add working capital to a business, and this is unquestioned. But there is no evidence before this Board that there was any opportunity to receive a large sum of capital or promote an influx of capital into this company by any of the means suggested.

As a result of the sale the proceeds after payment, as I recall, of some $60,000 in accounts payable by the company, was deposited in the company, and has not yet been removed by way of dividends or, so far as the evidence is concerned, by way of any bonus to the shareholders or any other persons.

There is filed as an exhibit, which I believe is Exhibit A-14, a letter from Provincial Insurance Agencies Limited addressed to W Hedley Wilson Limited, on the subject of Fredericton Housing and Construction Company Limited to the effect that in July of 1970 the Canadian Surety Company was prepared to provide a total guarantee limit of $1 /2 million, and its only condition was that any contract in excess of half a million had to have head office approval.

As a result the company was able to bid on several jobs. The evidence of Mr Bird was that it bid for and obtained one job, of some $700,000, I believe it was; one in excess of $200,000; and was able to bid on the Bathurst viaduct at $1 /2 million, although not successfully. The officers of the appellant were clearly now able to bid on jobs that heretofore had been unavailable to them and, in fact, have been able to tender on approximately thirty jobs per year under their new limits. So it is clear that this was a fortuitous sale for the company if it wished to carry on with its plans to construct larger buildings and undertake larger projects.

The question then arises as to whether or not in fact this was, as the appellant contends, an isolated transaction, a sale out of the normal business activities of the company, a transaction that should be treated as the disposal of a capital asset, or whether, as the Minister says, the company did what it had always intended to do, namely, dispose of this inventory asset at a profit and therefore the entire amount is taxable.

The evidence of Mr Profitt, the accountant, is that the auditors treated very loosely the books of these two companies because they were associated under the Income Tax Act, and many of the items that were sold in the name of Fredericton Housing Limited, the appellant company, were simply taken directly into the construction company accounts and journal entries were made to correct the situation. They were not concerned, as he said, with the formal transfer of legal title. This gave rise to a severe line of cross-examination on behalf of the Minister.

When one looks at the company’s return for the taxation year in question, its financial statement and, in particular, its balance sheet, the evidence is, and the pleadings indicate, that the accountant treated the serviced lots on which housing construction was going on as current assets, and other land, long-term holdings, as fixed assets. In the 1970 balance sheet there is no land shown in the current asset portion of the balance sheet, and the subheading “fixed assets” has been left out, although there is a subtotal of “land for future development”, and land, buildings and equipment are noted in the second half of the figures shown there.

Mr Profitt explains this by saying that at the time the auditors had taken out of the appellant company the current development lots and included them in the balance sheet of Fredericton Housing and Construction Company Limited, as shown in appellant’s Exhibit A-10, and that is why that land does not appear in the balance sheet filed with the 1970 return of the appellant company. He said that, as an accounting procedure, the actual sales are shown to have been made in the construction company so as to increase the working capital, even though, as I have said, the property might legally have been owned by the appellant company.

He said further, as l recall his evidence, that the land holdings were broken down into land being developed and built upon, land on which buildings and equipment were situate, and land for long-term development.

I accept the evidence of Mr Profitt and the explanation given by him with respect to the balance sheet attached to and forming part of the tax return of the appellant company for the year in question.

The respondent, also very properly, points out from a scrutiny of the books of the appellant company, the fact that within a year of the material sale, or for the sake of argument, at about the same time, it sold two pices of land, one to either the Province of New Brunswick or the City of Fredericton for school purposes in the Skyline area (this was developed land) for a profit of some $16,000 which was taken into income; and another lot for $10,000 at a gain of some $9,600, I believe it was, which again was taken into income. The latter part was sold to a firm known, I think, as Central City Investments Limited. In any event the buyers were interested in constructing a small shopping mall or supermarket in this area. Both projects, namely the school and the mall or shopping centre, were advantageous to the area as a whole.

This was serviced land that was sold, and it was sold just as if a house had been built on each lot and sold in the normal course of the company’s business. Perhaps the profit was, I think, unquestionably larger than would have been obtained from the sale of houses on these lots. But be that as it may, it was treated as part of the normal operation of the company and reported for tax purposes.

Mr Gorham at the outset, as I said, pointed out that land was one of the essential ingredients of home construction just as building materials are essential ingredients. It is not, as I pointed out during argument, possible for homebuilders, nor is it I think their practice, to finish one subdivision without having a. future site either purchased or available to move on to. The requirements outlined by Mr Graham in getting plans of subdivision approved are the conditions that exist in most provinces and municipalities throughout the country, and there would be a substantial delay if additional land was not available to move on to, and considerable loss of income, or potential income, to the company would result.

In my view, the land purchased from Fraser Companies on a longterm basis was an investment in the future of this company: it was a capital asset until brought into the normal trading aspect of the company by subdivision of lots on the land, or by, at the very least, the submission of a plan of subdivision for approval, on the particular land in question. In my view, until that happened, it was a capital asset, and what happened in this case was merely that the company transformed the capital asset, when the fortuitous offer from the housing authority was forthcoming, from land to cash; and that it was neither a sale in the normal course of the company’s operation nor was it, in my view, a venture in the nature of trade. It was nothing more than a conversion, as I have said, of a capital asset from land to cash, which allowed the company to continue its operation, and presumably enhanced the treasury of the country by creating taxable income from the appellant’s ability to branch out into more extensive construction.

For these reasons, supported by the evidence of the witnesses and supported by the exhibits filed, in my view the appellant has discharged the onus of explanation upon it in this case. The appeal will therefore be allowed and the matter referred back to the Minister for reassess- ment deducting the profit of this sale from the income of the company for the taxation year 1970.

Appeal allowed.