Kaneff Properties Ltd. v. The Queen, 95 DTC 5345, [1995] 2 CTC 177 (FCTD)

Rothstein J.:—The issue in this tax case is whether the gain on the sale of a commercial building by the plaintiff should be treated as a capital gain or as income.

Evidence on behalf of the plaintiff was given by Eric McKnight, executive vice-president of the plaintiff, and Joe Messmer, former vice-president, Commercial Lending (Ontario), for the Royal Bank of Canada. The plaintiff was incorporated in the 1950s. Its activities included the acquisition and development of revenue producing properties both to hold as investments and for sale, and the purchase and sale of raw land sometimes after rezoning.

In November 1970, the plaintiff acquired a five acre site in Mississauga fronting on The Queensway. In 1972, two acres not fronting on The Queensway were severed from the other three acres. The plaintiff constructed and sold condominiums on the two acres.

The remaining three acres fronting on The Queensway were considered to be a good commercial location. The plaintiff arranged for the rezoning of the land from agricultural use to a zoning that permitted the construction of office buildings. For six years, the property was held as raw land. In 1976, the land at the corner, 101 The Queensway, was leased, with option to purchase, to Kaneff Holdings Limited ("Holdings") a company related to the plaintiff. The remaining land, 89 The Queensway, remained with the plaintiff. The plaintiff and Holdings did some internal feasibility work and concluded that a seven-story, 73,000 square foot building at 101 The Queensway, would be feasible. One consideration was that the plaintiff would move its head office into that building and encourage other tenants over whom it had some control, e.g., its lawyers, accountants, to move in as tenants. Construction of that building was completed in 1977.

The plaintiff moved to the top floor and a portion of the next floor. The space was finished to a very high standard. By 1979, the building was 50 per cent leased and by 1983, it was 90 per cent leased.

Construction of a larger eight-story, 93,000 square foot building at 89 The Queensway was commenced in 1978 or 1979 and was completed in 1980. By 1983, this building was 80 per cent leased.

The two buildings were managed as one complex. There were common contracts for such things as cleaning, snow removal, and maintenance of boilers. Tenants were moved from one building to the other. There was a common driveway and some common parking.

In the meantime, the plaintiff was constructing multiple unit residential buildings (’’MURBs”) for sale. In 1982, the plaintiff was unable to sell any MURBs and Citibank, which was financing the MURBs stopped funding construction. In September 1982, the plaintiff turned to its primary bank, the Royal Bank of Canada, for assistance. However, the Royal Bank immediately became concerned with the plaintiffs financial position for the same reason Citibank had been. The Royal Bank required appraisals of properties and approvals of expenditures. Also, a requirement of weekly meetings between the bank and the plaintiff was imposed on the plaintiff.

Mr. McKnight testified and the documentary evidence indicates that the Royal Bank was pressing the plaintiff and Holdings to sell 89 and 101 The Queensway. However, the plaintiff and Holdings wanted to keep these properties and hoped to work out their financial difficulty by selling MURBs. This pressure from the bank continued through at least to the spring of 1983.

In September 1983, a reputable real estate broker in Mississauga asked Mr. McKnight to put a selling price on 89 and 101 The Queensway. Mr. McKnight calculated a price based on a cash flow assuming no vacancies and a capitalization rate of 9 per cent. The plaintiff and Holdings received unsolicited offers through the broker from Real Property Trust of Canada Limited almost identical to the price put on the properties by Mr. McKnight-for 89 The Queensway, $10,750,000 and for 101 The Queensway, $8,240,000, for a total of $18,990,000. The sum of $18,990,000 is to be contrasted with an appraisal done for the Royal Bank of Canada in December 1982, which valued 89 The Queensway at $8,255,000 and 101 The Queensway at $5,230,000 for a total of $13,485,000. The actual selling price was some forty percent (40 per cent) greater than the appraised value. (It should be noted that the plaintiff and Holdings were required to provide the purchaser with leasing guarantees which, when honoured, reduced the proceeds of sale by some $500,000 to $700,000. The amount remaining was still at least 35 per cent more than the appraised value.)

As a result of the unsolicited offers, Holdings exercised its option to purchase the land at 101 The Queensway from the plaintiff and thus 89 and 101 The Queensway were sold to Real Properties of Canada Limited for a total of $18,990,000 in November 1983.

Both the plaintiff and Holdings treated the sales as capital gains and not as income. The Minister accepted this treatment by Holdings for the building at 101 The Queensway but reassessed the plaintiff for the building at 89 The Queensway on the basis that the plaintiff should have treated the gain as income.

The cases deciding whether a gain on the sale of real estate should be treated as capital gain or as income are numerous. The applicable principles of relevance to this case are:

1. The onus is on the taxpayer to establish that the Minister’s assessment is in error. Johnston v. M.N.R., [1948] S.C.R. 486, [1948] C.T.C. 195, 3 D.T.C. 1065, at page 489 (CTC 202-3).

2. If the intention of the taxpayer at the time of the acquisition of the property was to trade, the property should be treated as inventory and the gain treated as income. Vern Krishna, The Fundamentals of Canadian Income Tax, 4th ed. (Scarborough: Carswell, 1992) at page 258.

3. If the taxpayer had, as an operating motivation for the acquisition of the property, a secondary intention of trading it if the primary objective of the acquisition was not realized, the gain will be treated as income. Regal Heights Ltd. v. M.N.R., [1960] S.C.R. 902, [1960] C.T.C. 384, 60 D.T.C. 1270, at pages 905-7 (C.T.C. 388-90, D.T.C. 1272), and Racine et al. v. M.N.R., [1965] C.T.C. 150, 65 D.T.C. 5098 at page 157 (D.T.C. 5103) (Ex. Ct.).

4. Generally, inferences flowing from the circumstances, and the conduct and actions of a taxpayer, are better indications of intention than assertions and direct evidence of witnesses. Pierce Investment Corp. v. M.N.R., [1974] C.T.C. 825, 74 D.T.C. 6608 (F.C.T.D.), at pages 830-32) (D.T.C. 6612).

For the reasons I shall set forth, I am not satisfied the plaintiff has met the onus of proving that its intention prior to 1976 was to hold the raw land at 89 The Queensway for investment purposes. As a result, the increase in the value of the land from 1970 to 1976 should be treated as income for tax purposes. However, from 1976 when the land at 101 The Queensway was leased to Holdings and plans were undertaken for construction at that site, until 1983 when 89 and 101 The Queensway were sold, I am of the opinion that the plaintiff’s intention was to retain 89 The Queensway as an investment. The change in the situation as of 1976 raises the question of whether the ability of the plaintiff to claim a capital gain is dependent solely on its intention at the time the property was purchased in 1970, or whether a subsequent change in intention is relevant. I will return to this point at the end of my judgment. First, I will review the evidence concerning the plaintiffs intention in the two relevant periods, 1970 to 1976 and 1976 to 1983.

I turn first to the period 1970 to 1976. Mr. McKnight was the only employee of the plaintiff to testify. While he had been employed with the plaintiff since January 1969, his evidence was that he was not involved in the purchase of the original five acres in 1970. There is, therefore, no specific evidence of the plaintiffs intentions at the time of acquisition. There is evidence that in 1972 two acres were severed for the purpose of constructing and selling condominiums. The three acres fronting on The Queensway remained as raw land although zoning changes were obtained to enable the construction of office buildings. Certainly, the three acres of raw land did not produce revenue and did cause the plaintiff to incur costs such as taxes and carrying charges. In addition to the evidence specifically relating to The Queensway property, there was also evidence that the plaintiff had been in the business of buying and selling raw land.

Mr. McKnight indicated that prior to 1976, the plaintiff considered several concepts for development of the property. He said an architect would have been hired, plans drawn up, rental rates checked and project costs determined to see if a project was feasible. He said that this process would have occurred two or three times.

Mr. McKnight’s evidence was very brief and vague about what transpired during this period. No documents were produced such as plans, drawings or cost estimates. Perhaps it is not unreasonable that the plaintiff would not have documents extending back over 20 years. Nonetheless, the plaintiff has the onus of demonstrating that the Minister’s reassessment is in error. There was no indication of any search for documents, or of calls to architects. There was no evidence as to the names of the architects or others involved in the concepts considered before 1976. The plaintiff has simply not made any effort to provide any details to support its assertion as to its intention with respect to the land prior to 1976.

Indeed, Mr. McKnight admitted that when the plaintiff acquired land it had two alternative objectives. One was to determine whether the property would make sense as a revenue producing property. The other was to consider the property as a straight land deal, in which case the plaintiff would try to earn income from selling it as raw land. He stated in direct evidence:

Q. How did you evaluate whether or not to undertake a new project? What did you typically look for?

A. Usually, first of all, our prime goal has always been to try to build a base of revenue-producing properties because the income stream is what will support you in lean times. And so the first thing we would try to figure out is whether this made any sense as a revenue-producing property. And we would go through some pro formas. And in those days it was pretty unsophisticated. We had a very good gut feel for the market and what land should be worth. But we did some rough pro formas and we tried to figure out if it made any sense as a revenue-producing property. It may not and we may have just looked at it as a straight land deal where maybe we could buy it today and hold on to it, either do a rezoning or just over time and sell it at that point and earn income. But generally those were the two criteria.

There is no suggestion that this approach did not apply to The Queensway property.

Even if I were to accept that the plaintiffs primary intention with respect to the three acres fronting on The Queensway was to develop the site into revenue-producing property for retention as an investment, it seems, on the evidence, that while the property remained as raw land, the plaintiff had a secondary intention of selling it if development did not prove feasible. It is true that the plaintiff held the land from 1970 to 1976 while there was no development activity, but in the absence of anything more concrete from the plaintiff as to its intention prior to 1976, and in particularly in light of Mr. McKnight’s evidence indicating a secondary intention, I do not think the plaintiff has satisfied the onus upon it of demonstrating that the Minister’s reassessment was wrong in respect of the period 1970 to 1976. Over this period of time, any appreciation in the value of the relevant land over its value in 1970 when it was acquired should be treated as income for tax purposes.

I next turn to the period 1976 to 1983. The land at 101 The Queensway was leased to Holdings in 1976 and construction of the office tower in which the plaintiff was to locate its head office was commenced. At this point, Mr. McKnight’s evidence becomes more specific. He explains why the site at 101 The Queen sway was developed first-it was on the corner and it was a smaller building than the one planned for 89 The Queensway, thus reducing Kaneff s exposure when first entering the market. He also explained why the plaintiff thought development and retention would be feasible-Kaneff had some control over a group of tenants such as its solicitors and accountants who would provide a good base of tenants to start the first building. Mr. McKnight explained how the two buildings were to be tied together through some common parking, a common driveway and common service contracts.

I think this evidence, which does not simply assert a state of mind, but demonstrates a specific action, supports the plaintiffs contention that, commencing in 1976, its intention was to develop the three acres fronting on The Queensway as two office buildings which it and Holdings would retain as revenue producing investments. This conclusion is supported by statements made by the plaintiff in 1983 when the plaintiff, then in financial difficulty, was, with Holdings, resisting pressure from the Royal Bank to sell 89 and 101 The Queensway. In response to this pressure, the plaintiff prepared a "corporate strategy" dated April 1983, which it submitted to the bank. The strategy states in part:

From the beginning Kaneff has been involved in all areas of real estate development; from the purchase and sale of raw land to the construction of various residential and commercial properties for retention or resale.

Historically, all buildings not specifically built for resale have been held. Where Kaneff has disposed of revenue producing property in the past, it has been for the purpose of simplifying operations....

In summary it is the philosophy of the group to provide cash flow from operations and income tax deferral through the retention of its revenue producing properties. In keeping with this philosophy Kaneff does not propose to sell any of these properties at this time.

[Emphasis added.]

I place significant weight on these statements because of the context in which they were written. They were not self-serving statements made to the Minister for the purpose of supporting a claim that the gain on the sale of real estate was capital gain and not income. They were written to the Royal Bank which had been urging the sale of 89 and 101 The Queensway. The statements not only demonstrate an intention not to sell in 1983, but more importantly, explain the historical approach of the plaintiff-to hold all buildings not specifically built for resale for investment purposes. I think this statement goes a long way to support the view that when the plaintiff and Holdings embarked upon developing the three acres fronting on The Queensway commencing in 1976, the plaintiffs and Holdings’ intentions were to retain, as investments, the office buildings that were to be constructed.

I am also satisfied that in 1983 the sale of the buildings at 89 and 101 The Queensway were pursuant to unsolicited offers at substantially more than fair market value. In addition to the difference between the total selling price and the appraisal done for the Royal Bank-in excess of $5,000,000-Revenue Canada itself admits the offers were unsolicited, and that they exceeded the fair market value, at least with respect to 101 The Queensway. I see nothing in the record indicating anything different for 89 The Queensway.

A Revenue Canada audit report of June 8, 1988, concludes that the gain on the sale of 101 The Queensway should be treated as capital gain. While the report asserts that there are reasons for dealing with 89 The Queensway differently, a careful reading of the report does not support such different treatment. The report states in part:

Although the two buildings are located side by side and were sold together to a single purchaser there are a significant number of factors which warrant dealing with 89 The Queensway differently....

101 The Queensway was held as a long-term asset and the intent of the company was not to sell but to earn rental revenues and long- term capital growth. Any gains on sale under these circumstances would normally constitute a capital gain.

Based on our review we have concluded that the company intended to use the building as its head office for an indefinite period....

We were unable to obtain any information suggesting that the company had attempted to sell the property to anyone other than the eventual purchaser, Real Property Trust.

It would appear that the company had been approached by Real Property Trust indirectly through a real estate agent.

Real Property Trust had as its primary intention to acquire commercial real estate using funds provided by mutual fund participants.

Real Property Trust (RPT) appears to have overpaid for the 101 The Queensway property. Review of valuation reports prepared by A.E. Lepage indicated the value before and after the sale was substantially lower suggesting RPT paid an amount in excess of FMV.

RPT subsequently developed severe financial problems. Recently, participants voted to wind up RPT and pay out any available cash. This is indicative of the manner in which RPT was managed providing further support to a higher than normal price being paid.

It would therefore appear that RPT submitted an unsolicited offer to KHI to acquire 101 The Queensway. The price offered was significantly greater than the then prevailing FMV for such a building. As a result KHI decided to accept the offer.

It would appear that the company’s filed position i.e., capital gain is the correct one. The circumstances between KHI owning 101 The Queensway and KPL owning 89 The Queensway can be differentiated and each should, and have been, evaluated separately.

[Emphasis added.]

Although the auditor says that 89 and 101 The Queensway should be treated differently, his observations, as far as I can understand them, apply equally to both properties. It is true that the plaintiffs head office was at 101 The Queensway but the evidence is that the two buildings formed one complex. In all other respects, especially the intention to hold as a longterm investment and the unsolicited offers at greater than fair market value, 89 and 101 The Queensway were in the same position. I am satisfied that from 1976 when it was decided to develop the three acres through to the time the buildings were sold in 1983, 89 The Queensway was held by the plaintiff for investment purposes. The plaintiff did not have a different intention with respect to 89 The Queensway than Holdings had with respect to 101 The Queensway. I am also satisfied, from the evidence, that the plaintiff did not have a secondary intention of trading 89 The Queensway, once the development decision was made in 1976.

Counsel for the Minister points to a number of circumstances that he says should cause me to conclude that 89 The Queensway was not constructed by the plaintiff with the intention of retaining it as a capital investment. He says that the plaintiff was in the real estate business for many years, and traded in land and development properties with the intention of sale. This is all correct. But the plaintiff also purchased and developed properties as investments. When there was a sale of such properties, Mr. Me Knight’s explanations were that there were special circumstances in each particular situation. While being in the real estate business might imply that a person had an intention to trade in real estate generally, I do not think such a conclusion is inevitable in respect of every property purchased and sold by the person. The nature of the individual’s business is only one factor to be taken into account in ascertaining intention. In the case at bar, I am not satisfied that the nature of the plaintiff’s business leads to the conclusion that the plaintiffs intention with respect to 89 The Queensway was development for the purpose of sale or indeed that it even had such a secondary intention. I think the plaintiffs Corporate Strategy, which explains the plaintiffs intention to hold commercial property as investments, must be given significant weight because, as I have said, it was written to convince a hostile bank that 89 and 101 The Queensway should not be sold, even in the face of significant financial difficulty. This evidence is specific to the properties in question and I think outweighs other more general inferences that might be drawn from the nature of the plaintiffs business.

Minister’s counsel says that the plaintiffs approach to financing was to invest as little cash as possible and obtain the greatest amount of leverage through borrowing. Indeed, this was Mr. McKnight’s evidence. However, there was no specific evidence as to the extent to which 89 The Queensway itself was leveraged. It does appear from the appraisal done in December 1982, which indicated a fair market value for 89 The Queensway of $8,255,000, that the first mortgage had an approximate balance of $5,400,000 or 65 per cent of the fair market value. Of more relevance, however, is the fact that the defendant’s auditor’s conclusion respecting the capital gains treatment for 101 The Queensway was not affected by the extent to which that property was leveraged. I see no reason why on this issue 89 The Queensway is any different.

Counsel for the defendant points out that the plaintiff got into difficulty with the Royal Bank in September 1982, that mandatory meetings with the bank continued only until the spring of 1983 at the latest and that there was a conspicuous absence of about five months between the last evidence of pressure from the bank on the plaintiff to dispose of 89 The Queensway and the Real Properties of Canada Ltd. offer to purchase of September 21, 1983. He submits that the pressure from the bank was not a motivating factor in the sale of the building.

Certainly, there is an absence of evidence of pressure from the bank after March or April 1983. However, I think this is of little significance. The plaintiffs position was that it was not going to sell 89 The Queensway. The motivating factor for the sale, as the Minister’s own auditor pointed out for 101 The Queensway, was the unsolicited offer from Real Properties of Canada Ltd. for both 89 and 101 The Queensway at a price significantly higher than fair market value. This was one reason why the auditor was satisfied that the gain on 101 The Queensway should be treated as a capital gain and I see no reason to treat the gain on 89 The Queensway any differently.

Counsel for the Minister submits that 89 The Queensway experienced a negative cash flow which would evidence an intention by the plaintiff to dispose of it. However, the evidence was that by the beginning of 1983 the building was 80 per cent leased. Mr. McKnight explained the plaintiff’s approach. He said that in the first five years after construction, the hope was to break even. It was not until the leases ’’turned over’’ after the first five years and rents were increased that the plaintiff expected to "show a positive return".

While 89 The Queensway may have been experiencing a negative cash flow, the plaintiffs financial problems were much more serious as a result of its inability to sell MURBs. Undoubtedly, in some cases, a negative cash flow on a building would support the view that the taxpayer intended to dispose of the building rather than hold it. But, in this case, the plaintiff s overall financial position was of much more importance than the negative cash flow on a specific building. There was no evidence that the plaintiff was attempting to sell the building to alleviate its financial position with the bank. The evidence is to the contrary. I do not think this is a case in which evidence of temporary negative cash flow assists the Minister.

Minister’s counsel says 89 The Queensway was held for only some three years following construction and that this infers an earlier intention by the plaintiff to sell it. However, the land had been held for seven years from the time development of the three acres started. In view of the plaintiffs resistance to sell, as asserted to the bank in the plaintiffs "corporate strategy" of April 1983 and, in the absence of overt efforts to sell, I do not think the absence of a longer holding period leads to the conclusion that the plaintiff intended to sell at any time after 1976.

I am satisfied on the evidence that although the plaintiff may originally have had a secondary intention to sell the land at 89 The Queensway if development did not prove feasible, once development started in 1976 with the property at 101 The Queensway, the plaintiff and Holdings were committed to develop the two properties as a complex and hold them as revenue-producing investments. The plaintiffs dealings with its bank also indicate the absence of a secondary intention to sell the building. The same considerations which caused the Minister’s auditor to conclude that the gain on the sale of 101 The Queensway by Holdings was a capital gain, leads me to conclude that the gain on the sale of 89 The Queensway from 1976 when development commenced to the time of sale, should also be considered capital gain.

Having come to this conclusion on the facts, the question remains whether the relevant intention for the purpose of determining whether the gain between 1976 and 1983 should be treated as capital gain or income is the plaintiffs intention at the time of acquisition of the land in 1970 or its intention at the commencement of development in 1976. Many cases refer to the taxpayer’s intention at the time of purchase of property. The usual case likely would be governed by intention at the time of purchase. However, there may be circumstances in which an intention might change. I have concluded that the relevant intention is that held by the plaintiff in 1976 when the decision to develop was made.

I am supported in this view by the words of Cattanach J. in Moluch v.

[1966] C.T.C. 712, 66 D.T.C. 5463 (Ex. Ct.). In that case, land which was originally purchased without the intention of trading, was subsequently converted to inventory when the taxpayer embarked upon the business of selling the land at a profit. At page 718 (D.T.C. 5466) Cattanach J. states:

[E]ven if, at the time of acquisition, the intention of turning the lands to account by resale was not present, it does not necessarily follow that profits resulting from sales are not assessable to income tax. If, at some subsequent point in time, the appellant embarked upon a business using the lands as inventory in the business of land subdividing for profit, then clearly the resultant profits would not be merely the realization of an enhancement in value, but rather profits from a business and so assessable to income tax in accordance with sections 3 and 4 of the Income Tax Act, R.S.C. 1952, c. 148.

In Edmund Peachey Ltd. v. The Queen (1979), [1979] C.T.C. 51, 79 D.T.C. 5064 (F.C.A.), Heald J.A. held that a change of intention to treat land as a capital asset rather than as a trading asset must be demonstrated by a clear unequivocal positive act. He stated at page 55 (D.T.C. 5067):

a clear and unequivocal positive act implementing a change of intention would be necessary to change the character of the land in question from a trading asset to a capital asset-and that on the facts here present, there was no evidence of such a positive or overt act. There was no documentary evidence to indicate that the new intention had been carried into reality, there was no dedicating of the land for another purpose. All that we have here is the expressed intention of the appellant to thenceforth hold the land as a capital asset. That is not, in my view, sufficient of itself to convert the proceeds of sale from trading proceeds to proceeds from the sale of a capital asset.

I am satisfied in this case there was a clear unequivocal positive act implementing a change of intention. At the time the property was purchased and while it remained raw land until 1976, the plaintiff did have a secondary intention to sell if development did not prove feasible. However, when development took place, commencing in 1976 with the property at 101 The Queensway, the sole intention of the plaintiff was to retain 89 The Queensway as an investment. The development in this case constituted the clear unequivocal positive act.

I conclude:

1. The gain in value of the land at 89 The Queensway for the period from acquisition to the commencement of plans for development of the three acres in 1976 must be treated as income.

2. The gain in the value of the land and building at 89 The Queensway for the period from the commencement of plans for development of the three acres in 1976 to the time of sale in 1983, should be treated as capital gain.

The Minister is instructed to reassess accordingly. If the parties are unable to agree to valuation in 1976, they may apply to the Court for determination of value.

If the parties are unable to agree to costs they may approach the Court. Costs will be settled upon hearing submissions by way of conference call.

Counsel for the plaintiff shall prepare an order consistent with these reasons and obtain approval as to form and content from counsel for the defendant and submit it to the Court for signature within 21 days of the date of these reasons.

Should the parties require further directions as a result of these reasons, they may apply to the Court.

Appeal allowed in part.