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 Department.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
CANADIAN TAX FOUNDATION ROUND TABLE
1998 ANNUAL CONFERENCE
SUBJECT: Reasonable Expectation of Profit - the Saga Continues
Issue:
Is there a reasonable expectation of profit (“REOP”) in essentially all deduction cases? Various cases from Tonn forward have sewn confusion.
Does this really add anything, practically, to “personal and living expenses” [18(1)(h)] and the general rule in 18(1)(a)?
Court Findings:
Recently, there has been a large number of REOP cases decided by the Courts, many of them are unreported. Discussed below are some of the more prominent cases.
- Enno Tonn, Rose Marie Tonn and Lester Sinanansingh v. The Queen (96 DTC 6001)
The Federal Court of Appeal decision allowed the taxpayers’ appeal of a REOP assessment on their rental property and implied the REOP test should be applied sparingly in cases such as this one, when a personal element or inappropriate activity is not involved.
- The Attorney General of Canada v. Michael Mastri and June Mastri (97 DTC 5420)
The Federal Court of Appeal overturned the Tax Court of Canada decision, by ruling there was no REOP and therefore the rental losses were not deductible. The Court also expressed the view that there was a personal element in the taxpayers’ situation (however the judgment was not decided on this point). The Federal Court of Appeal made the following findings:
- the Tax Court judge in Mastri misunderstood the Federal Court of Appeal decision in Tonn, when the Tax Court ruled that in order to deny a rental loss, it was not enough to find that there was no REOP. The Tax Court stated that there must also be a personal element or a foreseeable tax advantage;
- while a personal element or a foreseeable tax advantage is not a prerequisite for a finding of REOP, the Moldowan test should be applied “sparingly” when these elements are absent, using a common sense approach and not second guessing the business acumen of taxpayers (the reference to the Moldowan test being applied “sparingly” is not intended as a rule of law but as a common-sense guideline for Tax Court judges); and
- the objective criteria evolving from Moldowan continues to form the basis for any REOP determination.
- Zahid Mohammad v. Her Majesty the Queen (97 DTC 5503)
- The Federal Court of Appeal overruled the Tax Court’s decision on the application of section 67 to deny interest expense incurred from financing 100% of the purchase of the rental property. The Tax Court had previously ruled there was a REOP. The REOP point was not argued at the Court of Appeal.
- The Federal Court of Appeal, in allowing the taxpayer’s appeal, found that:
- the judicial doctrine of REOP and the concept of reasonable expenses are to be applied independently of one another; and
- there was no legal justification by the Tax Court in arbitrarily disallowing interest where property is acquired with 100% financing;
In its obiter dicta comments the Federal Court indicated that an operation may not have a REOP where a loss will be incurred due to financing costs. This could be the case where taxpayers fully finance a rental property and know from the outset that unless they reduce the amount of the indebtedness, they are going to realize a loss. In addition, they realize that they will have to rely on other income sources to meet their debt obligations relating to the rental property.
Law:
Section 9 of the Act sets out the basic rules for computing income or loss from a business or property. Subsection 9(1) stipulates that references to business income, such as those contained in section 18, are references to profit. This net concept, implies the deductibility of legitimate expenses.
In determining legitimate expenses, subsection 18(1) states that in computing the income of a taxpayer from a business or property no deduction shall be made in respect of...[paragraph (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 the business. Paragraph 18(1)(h) also states that in computing the income of a taxpayer from a business or property no deduction shall be made in respect of personal or living expenses of the taxpayer. Subsection 248(1) defines “personal or living expenses” to include the expenses of properties maintained by any person for the use or benefit of the taxpayer or any person connected with the taxpayer...and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit...”.
There is also the common law test requiring a reasonable expectation of profit, as expressed by the Supreme Court of Canada in Moldowan v. The Queen (77 DTC 5213). In the Mastri case Robertson, J.A. said the following regarding the articulation of the reasonable expectation of profit test in Moldowan:
First...in order to have a source of income a taxpayer must have a reasonable expectation of profit. Second, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. If as a matter of fact a taxpayer is found not to have a reasonable expectation of profit then there is no source of income and, therefore, no basis upon which the taxpayer is able to calculate a rental loss.
The distinction between the statutory tests in section 18 and the common law test in Moldowan are discussed at length in the Tonn decision. For instance, it states that the Moldowan test is stricter than the business purpose tests set out in subsection 9(1) and paragraph 18(1)(a). Those tests stipulate that a taxpayer be subjectively motivated by profit when incurring an expenditure. The Moldowan test, however, also requires the presence of a profit motive, but, in addition, it must be objectively reasonable.
Facts:
- Enno Tonn, Rose Marie Tonn and Lester Sinanansingh v. The Queen (96 DTC 6001)
The Tonn case concerned the acquisition of residential rental units, the financing of which originally included an interest free loan and a mortgage on the taxpayer’s principal residence. Rental losses were disallowed on the basis of no reasonable expectation of profit. The property was not used personally by the taxpayers.
- The Attorney General of Canada v. Michael Mastri and June Mastri (97 DTC 5420)
The taxpayers bought a condominium as their principal residence in December, 1990, virtually financing the entire purchase price. They rented the property for part of 1991, and then commenced living in it in December, 1991. Rental losses for 1991 were disallowed on the basis of no reasonable expectation of profit.
- Zahid Mohammad v. Her Majesty the Queen (97 DTC 5503)
The parties purchased a residential home in 1987, financing the entire purchase price. Their intention was to rent the property for a few years and then dispose of it, thereby realizing a capital gain. One of the owners rented the property for most of the time in question, paying arm’s length rent. The Minister disallowed the deduction of all rental losses claimed on the grounds (a) that there was no REOP; and (b) that his entire interest expense was unreasonable.
Taxpayer’s Position:
- Enno Tonn, Rose Marie Tonn and Lester Sinanansingh v. The Queen (96 DTC 6001)
The taxpayers purchased the property in 1989 to earn a source of rental property income. On the basis of their income and expense projections, and intended debt repayments, they expected to be earning profit from the property in 1992. They considered the rental operation a business and deducted the losses, accordingly.
- The Attorney General of Canada v. Michael Mastri and June Mastri (97 DTC 5420)
Although the property was initially acquired to be their principal residence, due to a job transfer from Burlington to Toronto, they rented out the property. Late in 1991, property values were declining and they were unable to find another tenant. Rather than selling the property they moved into it. If they had continued to rent the property, they would have shown a profit in 1992.
- Zahid Mohammad v. Her Majesty the Queen (97 DTC 5503)
There was a REOP and section 67 did not apply to disallow interest expense in respect of the rental property.
Department’s Position:
- Enno Tonn, Rose Marie Tonn and Lester Sinanansingh v. The Queen (96 DTC 6001)
The Department agreed with the decision, based on a factual finding that the taxpayer had a reasonable plan of action when the property was purchased. Based on the results thereof, the Department’s position is, or continues to be, as follows:
1. We will continue to review situations involving REOP where circumstances suggest that a personal or non-business motivation existed.
2. Where the enterprise was operated at a loss in order to generate tax benefits including, for instance, tax refunds, such that the activities did not constitute a business, the loss resulting therefrom will not be deductible.
3. A reasonable start-up period, although not automatic, should be allowed for emerging operations.
4. The test in the Moldowan case remains applicable, although to a lesser degree in cases where there is an absence of a personal element or inappropriate activity.
- The Attorney General of Canada v. Michael Mastri and June Mastri (97 DTC 5420)
The Federal Court of Appeal decision is correct. A personal element or a foreseeable tax advantage is not a prerequisite to a finding that there is no REOP. In addition REOP tests evolving from Moldowan are still valid.
- Zahid Mohammad v. Her Majesty the Queen (97 DTC 5503)
The Department agrees with the Federal Court’s findings in the application of section 67, and with the obiter dicta comments noted above concerning no REOP in certain fully financed rental property acquisitions. In the recent Brian Stewart decision (98 DTC 1600), the Tax Court of Canada found the obiter dicta in Mohammad to be instructive in making its decision that there was no REOP.
Author: Allan Nelson
File No.: 982235
Date: September 22, 1998
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