Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principal Issues: 2002 Canadian Tax Foundation Q & A regarding the Supreme Court of Canada decisions in Stewart and Walls.
Position: See below.
Reasons: See below.
This year the Supreme Court of Canada rendered its decision in two cases that concerned the application of the reasonable expectation of profit (REOP) test, B Stewart v. The Queen1 and The Queen v. Walls et. al.2
In the Stewart case:
? The taxpayer acquired four condominium units as part of a syndicated real estate development for $1,000 cash each. The balance of the purchase price was financed.
? Projections for rental income and expenses contemplated a negative cash flow. It turned out that actual rental losses were greater than projected.
? For the taxation years 1990 to 1992, the taxpayer claimed rental losses on the properties.
? These losses were disallowed on the basis that the taxpayer had no REOP and therefore, no source of income for the purpose of section 9 of the Act.
? Both the Tax Court of Canada and the Federal Court of Appeal upheld the reassessments.
In the Walls case:
? The taxpayers were limited partners in a partnership that purchased a mini-warehouse for $2,200,000, payable in the form of $1 in cash and the balance in the form of an agreement for sale with interest payable at 24% per annum.
? In addition to the interest on the debt obligation, the partnership also paid the vendor management fees and 50% of the net operating profit of the venture under a management and services agreement.
? The taxpayers deducted their proportionate share of the partnership losses incurred in 1984 and 1985.
? These losses were disallowed on the basis that the taxpayer had no REOP and therefore, no source of income for the purpose of section 9 of the Act.
? It was also argued that the losses should be decreased by:
o Reducing the purchase price of the mini-warehouse to reflect a fair market value of $1,180,000; and
o Reducing the interest expense by decreasing the debt in excess of the fair market value and lowering the interest rate to 16%.
? The taxpayers filed notices of objection, but the Minister confirmed the reassessments.
? The Federal Court, Trial Division, dismissed the appeals and upheld the Minister's position with respect to REOP.
? The Federal Court of Appeal set aside the judgment, holding that the trial judge erred in applying REOP since the taxpayers did not have a personal motivation. It remitted the matter to the trial judge for a determination of the outstanding issues of whether the transaction was arm's length and at fair market value.
? The issue of whether the storage park operation constituted a source of income for the purpose of section 9 of the Act was appealed to the Supreme Court.
In both cases, the Court ruled in favor of the taxpayers. In its decision in Stewart (the analysis from which, also formed the basis for the decision in Walls), the Court stated the REOP test is not supportable by law as a basis to determine if a taxpayer's activities constitute a source of income under the Act.
Question 1
Before getting into the impact of the decisions, could you briefly explain the basis for the CCRA's previous position that a business or property that had no REOP was not a source of income under the Act?
Response 1
The CCRA's previous position was based mainly upon the Supreme Court decision in William Moldowan3 . While the Moldowan case involved the determination of whether a taxpayer's chief source of income was farming, the court noted that in order to have a source of income under the Act, the taxpayer must have a profit or a REOP. Further, in determining if a taxpayer has a REOP, the following criteria should be considered:
? The profit and loss experience in past years;
? The taxpayer's training;
? The taxpayer's intended course of action; and
? The capability of the venture as capitalized to show a profit after charging capital cost allowance.
Question 2
What impact will the Court's decision have on the CCRA's use of the REOP test?
Response 2
The Court has stated that the REOP test should not be accepted as a basis to determine if a taxpayer's activities constitute a source of income under the Act. The courts have suggested a two-stage approach:
? The first stage is to determine whether a taxpayer's activity is undertaken in pursuit of profit that results in a source of income under the Act, or is a personal endeavour. This first stage is only relevant where there is some personal or hobby element to the activity. The venture will be considered a source of income only if it is undertaken in a sufficiently commercial manner.
? In the second stage, pursuit of profit has been established and the taxpayer's activity is clearly commercial in nature. It then becomes a matter of determining whether the source of the income is from business or property for purposes of the Act.
Question 3
Does this mean that the REOP test is no longer applicable in determining if a taxpayer has a source of income under the Act?
Response 3
? The REOP test, as it previously applied, will no longer be used to determine if there is a source of income under the Act.
? The CCRA will, however, question whether a taxpayer is operating in a sufficiently commercial manner when the activity has some personal or hobby element.
? At this point, a taxpayer's venture will be reviewed and criteria, including those set down in Moldowan, will be considered in determining if the taxpayer intends to carry on an activity for profit and the overall evidence supports that intention.
Question 4
Could you comment on the part of the Court's decision in which it was stated that the realization of an eventual capital gain may be taken into account in determining whether a taxpayer's activity is commercial in nature?
Response 4
? The Court has stated that the motivation of capital gains accords with the ordinary businessperson's understanding of "pursuit of profit."
? Thus, the CCRA accepts that there may be situations where the realization of an eventual capital gain will be a factor in assessing the commerciality of the taxpayer's overall course of conduct.
? However, it is emphasized that the mere acquisition of a property in anticipation of a capital gain does not provide a source of income.
Question 5
Do you have any concerns that these comments seem to imply that a capital gain may be considered to be part of a source of income that is from a business or property?
Response 5
? As noted above, the acquisition of a property in anticipation of a capital gain does not provide a source of income under the Act.
? The proposition that a capital gain is now included in calculating income that is from a business or property source would be contrary to the overall scheme of the Act.
Question 6
If a taxpayer's loss is not from a source of income under the Act because the activity in question is not carried on in a sufficiently commercial manner, say for example in the case of a recreational property, will the expenses that generated the loss be deductible in calculating a capital gain from the disposition of a property?
Response 6
No.
? Pursuant to paragraph 40(1)(a) of the Act, only outlays and expenses incurred for the purpose of disposing of a property will be deductible in the calculation of the gain.
? The courts have stated that the phrase "for the purpose of" in subparagraph 40(1)(a)(i) means "for the immediate or initial purpose of" and not the eventual or final goal which the taxpayer may have in mind.4
? Therefore, if a taxpayer's activity is not of a commercial nature, the annual expenses incurred in relation to that property may not be carried forward and deducted in the calculation of a capital gain or loss when it is disposed of.
Question 7
Assuming a taxpayer's activity is commercially viable, but there is a personal element, how will the CCRA account for the expenses related to the personal element?
Response 7
? It is the CCRA's view that a calculation will have to be made using some reasonable basis, to determine the amount of the business expenses that may be deducted in calculating the income from the commercial activity.
? Thus, where there is both a personal and business element to the expenses incurred and they are not otherwise restricted under the Act, some reasonable basis of proration will have to be used to determine the portion that relates to the business activity.
Question 8
If a taxpayer's involvement in a venture is motivated by tax considerations, will this be viewed as a personal element such that it could affect the determination of whether the activity has a sufficient degree of commerciality to be considered a source of income under the Act?
Response 8
If a taxpayer is motivated by tax considerations when he or she enters into a business or property venture, this will not detract from the venture's commercial nature or characterization as a source of income under the Act.
ENDNOTES
1 B Stewart v The Queen (2002 SCC 46)
2 The Queen v Walls et al (2002 SCC 47)
3 William Moldowan v Her Majesty The Queen (77 DTC 5213)
4 See the Federal Court of Appeal decision in Avis Immobilien G.M.B.H. v. The Queen (97 DTC 5002)
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