Date: 19980108
Docket: 97-1035-IT-I
BETWEEN:
FRANCIS NICHOLSON,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Agent for the Appellant: Keith Bannon
Counsel for the Respondent: Nicole Levasseur
____________________________________________________________________
Reasons for Judgment
(Delivered orally from the Bench at Ottawa, Canada, on January
8, 1998)
Bowie, J.T.C.C.
[1]
These appeals concern the Appellant's claim to be entitled,
when computing his income under section 3 of the Income Tax
Act (the Act), to deduct from his other income the
losses sustained by him in connection with renting two
apartments. The Minister of National Revenue (the Minister) has
reassessed him for the 1992, 1993 an 1994 taxation years, to
disallow the losses claimed of $9,708, $7,447 and $5,752,
respectively. The Minister's contention, shortly stated, is
that in the years in question the Appellant did not have a
reasonable expectation of making a profit from the rental
operation, and that it was therefore not a business, and not a
source of income within the meaning of that expression as it is
used in section 3 of the Act.
[2]
In 1984 the Appellant and his wife, foreseeing retirement, sold
their house and purchased a triplex in the village of Jasper,
which is about 10 kilometres from Smiths Falls, Ontario. It
consisted of three living units, the largest of which they moved
into with their family. The two smaller units were rented to
tenants who remained for some years after the purchase and paid a
monthly rent of $220.00 each. These tenants eventually moved out
(the evidence is unclear as to exactly when), and by 1992 one of
the apartments was occupied by the Appellant's daughter,
who works nearby, and the other by Mrs. Nicholson's mother,
who was infirm and had previously lived in a seniors' home.
Although the evidence is scant, it appears that both of them paid
rent at about the market rate.
[3]
The purchase price of the triplex in September 1984 was $45,000.
It was paid for with the $15,000 equity which the Appellant and
his wife had built up in their previous home, and a $30,000
mortgage with an interest rate of 17½% per annum. Over the
next several years the mortgage was replaced a number of times.
In December 1985 it was increased to $40,000, at a rate of 12%
per annum; in November 1988 it was further increased to $75,000
at 11.75%; in June 1991 it was increased again, this time to
$85,000 at 11.53%; this last mortgage was renewed in January 1994
at a rate of 7.75% per annum, and by the date of the trial in
January 1998 the principal outstanding had been reduced to
$53,000. The Appellant testified that these increases in the
mortgage had all been to provide funds for necessary capital
expenditures on the property which he and his wife had not
foreseen at the time they bought it. These included a new roof, a
new septic system, and a new well. There was little evidence
about the cost of these items, but counsel for the Crown did not
challenge the Appellant's statement that he took no money
from the mortgage advances, except so far as necessary to make
these improvements of a capital nature.
[4]
The Appellant's position is that when he and his wife
bought the triplex it was a viable business proposition from
which they could expect to derive profits, and that this changed
only because of the capital expenditures which required them to
increase their mortgage debt by as much as $55,000 by June 1991.
He testified on cross-examination that they had a plan for the
property which would have seen it produce a profit; however he
gave no evidence of what that plan was. Nor was any income
statement, pro forma or otherwise, for the early years put
into evidence. The Reply to the Notice of Appeal sets out in
paragraph 9(c) the history of gross rental income and losses
claimed by the Appellant in relation to the property over the
eight years from 1987 to 1994, and these were not disputed.
Year
Gross rental
income
Net Rental Loss
1987
$8,842
$5,622
1988
$9,090
$1,038
1989
$5,805
$5,920
1990
$7,610
$5,758
1991
$7,950
$5,542
1992
$6,575
$9,708
1993
$7,600
$7,447
1994
$7,040
$5,752
To these can be added the corresponding numbers for the years
1995 and 1996 which were put into evidence by counsel for the
Respondent.
1995
$8,040
$3,665
1996
$8,440
$1,228 profit before CCA
[5]
The losses for the eight years from 1987 to 1994 total $46,787.
The Respondent relies on this history of losses as demonstrating
that there has never been a viable business with the potential
for profit, and certainly not in the years under appeal. The
Appellant says that if he had not been subject to the misfortune
to have had to make very large and unanticipated capital
expenditures then there would have been profits prior to the
years under appeal.
[6]
It is clear from the loss claims made by the Appellant in his
income tax returns that he has been prone to calculate his losses
in a way that tends to maximize them to a degree not warranted by
the facts. During the years 1992 to 1996, which are the only
years for which the income statements are in evidence, he
consistently attributed one-third of the expenses for insurance,
mortgage interest, taxes and utilities to the personal use of his
family, and two-thirds to the rental units. No floor plan of the
whole building, or measurements of the various living areas, was
put into evidence. When asked on cross-examination about the
relative areas of the personal use and rental parts of the
building, the Appellant first said that it was about 50% to 60%
personal living area. He later said it was 50%. Later still, he
said that it was really 33.3%, as applied by him in filing his
returns, because one tenant, his mother-in-law, was permitted
some occasional use of a stairway and passageway to have access
to the laundry room, and use of the laundry room itself, three
times per week, and occasional use of a stairway and hallway for
ingress and egress through the family's living quarters,
also about three times per week. These areas, used by her only
occasionally, amount to some 200 square feet. The whole
building is about 4,000 square feet. The occasional common use of
some 5% of the building does not in my view significantly alter
the personal to business use ratio; certainly it does not reduce
it from 50% to 33.3%. I find that the appropriate ratio in which
to attribute these expense items is 50% to the personal use of
the Appellant's family, and 50% to the two rental
units.
[7]
In each of the years from 1992 to 1996 the Appellant claimed to
be entitled to reduce his other income by the full amount of the
losses, as calculated by him, even though he testified that the
house was owned jointly by him and his wife. He offered no
explanation for this.
[8]
In his direct examination the Appellant testified that his
purpose in buying the triplex was to provide additional income to
supplement his retirement income. On cross-examination he was
confronted with the answers that he had given to a questionnaire
some two years earlier. One question and answer therein are as
follows:
4)
What was the initial purpose of acquiring the property?
We moved to the bigger house to accommodate all our family
members. Husband, wife and four children. We also hoped that the
rent from the two apartments would help with our mortgage
payments.
[9]
During argument I permitted the Appellant, who was represented by
an inexperienced agent, to re-open his case to give the evidence
about shared use of part of the premises to which I have referred
above. That evidence is totally inconsistent with his statement
in the questionnaire that no facilities are shared between the
landlord and the tenant. He attempted to explain these
inconsistencies by saying that the questionnaire had been
completed by his wife, and that he had signed it without reading
the answers. At that point his agent, to his credit, informed me
that the answers to the questionnaire had been completed by him
in his office while the Appellant sat across from him giving him
the information. The Appellant then signed it, below the
words:
I hereby certify that the information given in this
questionnaire and in any documents attached is true, correct and
complete in every respect.
[10] For these
reasons, and because of the degree to which he strove to be
self-serving in his answers, I have little confidence in the
Appellant's evidence.
[11] Counsel
for the Respondent argued that I should view this case as being
one involving a strong personal element, and therefore subject to
the closest of scrutiny as to the bona fides of the
alleged business, in accordance with the decision of the Federal
Court of Appeal in Tonn v. The Queen.[1] Certainly the question and
answer which I have quoted above as to the intention of the
taxpayer at the time of purchase gives some support to that view.
So too does the fact that the tenants, during the years under
appeal, were both immediate family members. However, the building
is a triplex, and, as I understand it, was originally built as
such. The original tenants were unrelated to the Appellant. Nor
do I attribute great importance to the Appellant's answer
to the question as to intention in the questionnaire to which I
have referred. I very much doubt that either the Appellant or his
agent would have appreciated any significant difference between
making a profit and hope that the rent would help with the
mortgage. On balance, I believe it is proper to view this as a
case where the Appellant's subjective intention was to make
a profit. The question which remains, then, is whether or not,
applying the objective criteria to which authority directs me,[2] the Appellant
could be said to have had a reasonable expectation of profit at
the appropriate point in time.
[12] An
operation may begin with a reasonable expectation of profit, and
yet later prove, after an appropriate start-up period, to be so
unsuccessful that it can no longer be said to have a reasonable
expectation of profit, with the result that it can no longer be
said to be a business, and therefore a source of income, for the
purposes of section 3 of the Act. Similarly, an operation
with no potential for profit, as initially structured, may
acquire that potential through as a result of changed
circumstances. This is such a case.
[13]
Unfortunately, I have little evidence before me as to
profitability in the early years. However the known facts do
demonstrate that in 1987 the loss reported of $5,622 greatly
exceeds the total amount of interest that could be attributed to
the rental units, which is approximately $2,400. The loss
reported for 1991, $7,950, considerably exceeds the total
attributable mortgage interest of approximately $4,650 in that
year. These are the first and the last of the years prior to the
years under appeal for which some data are available.
[14] I turn
now to the years under appeal. The Appellant attributes his
losses in these years to the high interest costs arising out of
the capital expenditures in earlier years. The reported losses
are also inflated by his attribution of 66.6% of the expenses to
the rental units. However, when the losses are recalculated on
the basis of an apportionment of 50% to the rental units, the
following picture emerges for the years under appeal, and the two
years thereafter:
Year
Reported
loss
Adjusted
loss
Interest Adjusted loss net
of interest
1992
$9,708
$6,543
$4,713 $1,830
1993
$7,447
$4,302
$4,587 $ 285 profit
1994
$5,753
$3,224
$3,169 $ 55
1995
$3,665
$2,822
$2,567 $ 255
1996
$1,228 profit
2,443
profit
$2,337 $4,780 profit
[15] This
demonstrates that the Appellant's rental operation did not
have a potential for profit as it was structured prior to the
reduction of the mortgage interest rate to 7.75% in January 1994.
The inability to show a profit in earlier years is not
attributable simply to the fact that the mortgage principal was
greatly increased between 1984 and 1991. Even if the Appellant
had paid no interest at all, he would have seen no profit until
1996, except for $285 in 1993, which takes no account of capital
cost allowance.[3]
Real profit from these units was realized for the first time in
1996 a fact which I find is attributable to two factors which
could not be foreseen prior to 1994. One is a significant
increase in the gross rental income in each of the years 1995 and
1996. The other is the renewal of the mortgage in January 1994 at
7.75% per annum, a decrease of almost 4% from the prior years,
and almost 10% from the original rate. I find that a reasonable
expectation of profit emerged in this case for the first time in
January 1994, and that the Appellant is therefore entitled to
take his losses from the property into account in computing his
income for that year only.
[16] The
appeals for the taxation years 1992 and 1993 are dismissed. The
appeal for the taxation year 1994 is allowed; the assessment is
referred back to the Minister for reconsideration and
reassessment on the basis that in computing his income under
section 3 of the Act, the Appellant is entitled to take
into account his losses from the rental property, not as they
were reported by him, but as properly ascertained on the basis
that 50% only of the expenses relating to insurance, mortgage
interest, property taxes, utilities, garbage removal, snow
plowing and lawn mowing are attributable to the rental
operations, and that 50% only of the net loss for that year, so
calculated, is allocable to the Appellant, the other 50% being
allocable to his spouse as co-owner of the property.
Signed at Ottawa, Canada this 8th day of January 1998.
"E.A. Bowie"
J.T.C.C.
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