Zator v. R., [1997] 3 C.T.C. 3094

Hamlyn T.C.J. (orally):

1 This is in the matter of Todd Zator and Her Majesty The Queen and it is an appeal with respect to the 1991 and 1992 taxation years. In computing his income for the 1991 and 1992 taxation years. Mr. Zator claimed rental losses in the amount of $7.183.60 and $10,061.89. In reassessing Mr. Zator for the 1991 and 1992 taxation years, the Minister of National Revenue disallowed the deduction of the rental losses.

2 Mr. Zator has presented his appeal in the document that was filed as a notice of appeal, and he adopted the contents of that notice of appeal as part of his case today. He also gave me the benefit of his oral evidence today in relation to an expansion of the points that he made in his notice of appeal.

I am going to read from his appeal document the following, which outlines pretty well. I think, from his evidence what is the basis of his appeal. He states: “My appeal was denied based on Revenue Canada's assertion that there was not a reasonable expectation of profit. My argument is that the house was purchased with the expectation of generating a profit within a reasonable period of time. In the documentation submitted. I have shown that my original projections were based on reasonable and supported assumptions and clearly show that based on these assumptions, a profit was generated in year three. The reason a profit was not generated in 1992 was a direct result of uncontrollable factors; that is, rental rates dropped, vacancy rates increased, expenses were higher than expected. This is further supported in the detail attached.

I have also shown that during the period in which we held the property. I made a conscious effort to improve the profitability of the rental unit by improving the area, making significant efforts to reduce the costs; that is, mortgage paydown, reduced electrical costs due to better insulation and windows.

Significant costs were expended, most of which were not expensed during the period. Costs were kept down by myself doing a bulk of the work. This is further elaborated in the attached correspondence.

I have also shown that had we continued to live in the house, based on current market conditions and current costs, a profit would have been generated in 1995 and thereafter. Unfortunately, in 1992, my son was born with a significant number of birth defects. This forced my wife to give up her employment, which had a direct result on our ability to further reduce operating costs associated with the rental property; that is, further mortgage paydowns.

The most difficult problem associated with our son was that he had a tracheotomy. Since Hamilton Hall was electric heat, the air did not circulate and was not free from germs. This resulted in Alexander's health being poor due to colds, germs, et cetera.

We decided in late 1993 that the electric dry heat and non-circulating air in Hamilton Hall was hampering his ability to thrive. As a result, we moved from Hamilton Hall to a new home in early 1994, with circulated clean air, which we acquired with relatives.

Finally, I am a chartered accountant and as such have a good business perspective. I acquired the house just before the Toronto market peaked. Unfortunately, many of the assumptions I had made at that point did not come to fruition as the market crashed. My intention, however, at the time of acquisition was to hold the property for a long-term basis and to earn a profit within a reasonable period of time.

All these factors had been set out to Revenue Canada. I also enclosed a copy of the case Sipley v. The Queen, which was reviewed under the informal procedure, and represents a case which is almost identical to my own. Not only does this case deal with a denial of rental losses, the said property is within four miles of my own.

This case combined with other factors of my own case support the fact that there was a reasonable expectation of profit.

• (1) In June 1989, the appellant purchased the property located at 16 Hamilton Hall Drive in Markham. Ontario, as his principal residence.

• (2) During 1991 and 1992, the appellant rented out part of the property to other persons.

• (3) During 1991 and 1992, the appellant reported rental income, expenses and losses from renting the property as follows: In 1991, income $7,900.07, expenses $31,426.00, less a personal portion of $16,342.47, leaving expenses of $15,083.60. For the balance against the income, the losses that came from that year was $7,183.60. For 1992, the income was $5,850.00, the expenses were $31,266.16, less the personal portion of $15,354.27, leaving the expenses at $15,911.89. When that is deducted against the income, the net loss became $10,061.89.

4 Now, the Minister's position was -- and this was disagreed with by the appellant -- that the appellant rented part of the property to help defray the cost of maintaining his principal residence; the appellant did not incur the expenses in the 1991 and 1992 taxation years to maintain a bona fide rental operation; the rental expenses were in excess of the amounts allowed and were not made or incurred or if made and incurred were not for the purpose of producing or gaining income from the business or property; that the appellant had no reasonable expectation of profit from renting the property during the 1991 and 1992 taxation years; and lastly, the rental expenses were personal or living expenses of the appellant.

5 The issues as defined from the pleadings are whether the appellant had a reasonable expectation of profit from the rental of the property in the 1991 and 1992 taxation years; whether the rental expenses claimed by the appellant in the 1991 and 1992 taxation years were made for the purpose of gaining or producing income from the business and property; and in the alternative, whether the disallowed expenses were reasonable in the circumstances.

6 In terms of legislation and jurisprudence. I will cite certain aspects of the law that I have cited in other cases including the Sipley case [ Sipley v. R. (1994), [1995] 2 C.T.C. 2073 (T.C.C.)]. A reasonable expectation of profit is an objective test and not just a fanciful dream. The objective test includes an examination of profit and loss in past years. The test also includes the operational plan and the background to the implementation of the operational plan, including the planned course of business action.

7 The test further includes an examination of the time spent on the activities as well as the background activity of the taxpayer and the education and experience of the taxpayer. Other criteria include the time required to establish the intended business, the presence or absence of ingredients leading to profits, the records of profit and losses, the cause of the losses and the flexibilities and actions of the taxpayer to make adjustments in the face of the losses.

8 Where there has been no actual profit, it would appear from that fact alone that there is a presumption against the finding of a reasonable expectation of profit. However, this presumption can be rebutted by the evidence submitted on behalf of the taxpayer.

9 And since the Sipley case, we have now had the Tonn case added, and I wish to add my own comments in relation to Tonn. As indicated, reasonable expectation of profit has recently been explored by the Federal Court of Appeal in Tonn v. R.[(1995), [1996] 1 C.T.C. 205 (Fed. C.A.)] and generally, Linden, J.A., Justice of the appeal, is critical of the courts for applying the test too strictly and for substituting the judge's business judgment for that of the taxpayer. He states at page 6009 that:

The tax system has every interest in investigating the bona fideness of a taxpayer's dealings in certain situations, but it should not discourage, or penalize honest but erroneous business decisions.

Consequently, when the circumstances do not admit of any suspicion that a business loss was made for personal or a non-business motive, the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgment may have been less than competent.

10 And he goes on further to say:

Where circumstances suggest that a personal or other-than-business motivation existed, or where the expectation of profit was so unreasonable as to raise a suspicion, the taxpayer will be called upon to justify objectively that the operation was in fact a business. Suspicious circumstances, therefore, will more often lead to closer scrutiny than those that are in no way suspect.

11 The courts have further considered another test as to whether there is a carrying-on of business. That requires analysis in terms of the preponderant purpose test. This was in the Supreme Court of Canada in Ontario Regional Assessment Commissioner v. Caisse populaire de Hearst Ltée. That was found in[1983] 1 S.C.R. 57 (S.C.C.). And at page 64 it was held:

The preponderant purpose test is based upon a determination of the purpose for which the activities were carried on. If the preponderant purpose is the making of a profit, then the activity may be classified as a business. However, if there is another preponderant purpose to which any profit earned is merely incidental, then it will not be classified as a business.

12 It is with this jurisdictional and legal analysis that I must consider the facts of this case.

13 The first factors I will consider is the personal or other motivation as dictated by the Tonn decision. In this case, the place of the rental operation was the principal residence of the appellant, his spouse and their family. The birth of the appellant's son with his special needs caused the appellant and his spouse to sell the principal residence. The significant personal factors had a determinative affect on how the rental activity was operated. I conclude the rental activity was an integral part of the family and the family needs dictated how the approach to the activity was to be made.

14 The next question to consider is whose rental activity was it? The appellant maintained it was his own. However, he and his spouse owned the property jointly. The activity was operated from their joint bank account. The spouse's work activity was deemed necessary to increase capitalization from the stated business plan. Thus, from these factors, I conclude the rental activity was operated both by the appellant and his spouse. The appellant's arguments.

15 The appellant states the factors that affected the rental operation's profitability were declining interest rates, the increasing vacancy rates, and higher than expected expenses.

16 From this I conclude, however, given all the evidence, the appellant was not an unsophisticated person. He is a practising CA and is aware of business practice and what constitutes business expectations. Business does not operate in a vacuum and the factors cited by the appellant are not abnormal, nor beyond the anticipation of a normal business cycle.

17 The appellant's arguments in relation to the comparison of the Sipley case I will now consider.

18 In Sipley, the appellant was experienced in property business, both as an employee and as a landlord. Mr. Sipley had the ability to make substantive adjustments in the face of business adversity. Mr. Sipley had the ability to significantly increase the capitalization. Mr. Sipley in prior rental businesses had a profit history.

Conclusions from this case.

19 The personal factors, I conclude, predominated the whole rental operation decisions. The fixed costs, the mortgage interest, the property taxes, and the insurance were more than the rent charged, and I also conclude this is the same for the 1993 taxation year which the appellant wished me to consider in his submissions before the court.

20 The rental operation was under-capitalized without a substantive ability to increase capitalization to reduce fixed costs. To reduce his costs for 1993, the appellant reduced the square footage of the rental operation. To me I have come to the conclusion that this, in effect, was a form of manipulation of the data. The preponderant purpose, I conclude from all the evidence, was an operation of a rental activity to help support the principal residence of the appellant and his spouse and their family.

21 This conclusion, unfortunately for the appellant, fails the necessary business purpose test. On this conclusion, I am sorry to say to the appellant, I must dismiss your appeal.

22 Thank you for your presentation. You spent a lot of time in putting it together. I am not able to agree with you and that is court. At least I had the opportunity of hearing you, and hearing you in full, and I appreciated the effort you have put into it. The appeal is dismissed. Thank you.