Date: 20010724
Docket: 2000-2720-IT-I
BETWEEN:
MOHAMED KARMALI,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Agent for the Appellant: Richard Rooney
Counsel for the Respondent: Suzanne M. Bruce
____________________________________________________________________
Reasons for Judgment
(Delivered orally from the Bench, at Toronto, Ontario, on
June 8, 2001)
McArthur J.
[1]
As a result of an audit in respect of condominium rental losses,
the Minister of National Revenue reassessed the Appellant for the
1995 and 1996 taxation years disallowing the deduction of losses
and undepreciated capital cost balance at the end of 1996. The
Appellant appeals those reassessments. He is a medical doctor
presently with the Federal Department of Health and did not
attend the hearing. The evidence was presented by Barry Flodder,
the Appellant's accountant of 15 years. Richard
Rooney, C.A. acted as the Appellant's agent and he was given
time to attempt to contact the Appellant to attend the hearing
but being unable to reach him, the agent chose to proceed.
[2]
During the 1995 and 1996 taxation years, the Appellant was
employed as a medical doctor at Toronto's Sick
Children's Hospital. The following assumptions of fact in
the Reply to the Notice of Appeal were agreed to:
7(b) the
Appellant acquired a unit in a condominium building located at
the Atriums in Kanata, Ontario (the "Property") in 1987
for a total purchase price of $131,998 as a tax shelter;
7(c) the
property was financed 99% by a mortgage and a promissory note in
the total amount of $130,998;
7(d) the
Appellant paid a premium to obtain special financing and revenue
guarantees in respect of the Property;
7(e) the
premium was amortized over five years, increasing the rental
losses reported for those years;
7(f)
beginning in 1987, the Appellant rented the Property;
7(g) from 1995
to 1996, the Appellant reported rental income and expenses and
losses from the Property as follows:
YEAR INCOME INTEREST TOTAL
EXPENSE
EXPENSES LOSS
1995
$5,335 $8,038
$10,291 $4,956
1996 $4,893
$6,874 $ 9,146 $4,253
The income referred to above was reported by the Appellant in
his income tax returns and according to Mr. Flodder, that
income is misleading in that his unit had a higher income for
those years, I believe in the neighbourhood of $9,000. With the
condominium pooling arrangements, however, the income was reduced
to the figures claimed. The Appellant was not actively involved
in the rental operation.
7(j) the
Appellant also reported net rental losses for the previous eight
years as follows:
YEAR RENTAL LOSS CLAIMED
1987
$17,168
1988
$14,193
1989
$10,229
1990
$ 9, 644
1991
$12,516
1992
$ 7,654
1993
$ 7,172
1994
$ 6,570
These rental losses claimed total approximately $85,000.
[3]
There are many reasons for the lower rents and higher costs than
projected or anticipated by the Appellant, including poor rental
management, shoddy construction of the building that became
expensive, the vendor went bankrupt and could not honour his
rental guarantees, an expensive lawsuit followed, and so on. By
claiming the losses, the Appellant reduced his income from other
sources. Finally, the Appellant sold the property in February
1998. I believe the sale price was $79,000.
[4]
Mr. Flodder stated that he was more familiar with the
figures than the Appellant which is likely. He presented a Rental
Questionnaire (Exhibit A-1) purportedly prepared by the Appellant
and the first question and answer of that Questionnaire is as
follows:
1.
What was the initial purpose of acquiring the property?
The initial purpose was to earn income on an ongoing basis. The
expectation of earning income, which was the only motive for
purchasing the property, was based on the original sales pitch of
the developer. There was clearly no interest in the personal use
of the property since I was then and remain now a resident of
Toronto, whereas the property is in Ottawa. I have no
relatives living in Ottawa.
The Appellant based his decision to purchase, apparently, on a
one-page proforma, (Exhibit A-2), prepared by the
developer, which projects the taxation years 1986, 1987, 1988 and
1989. The property was not rented in 1986. The proforma, if I can
call it that, demonstrates a taxable income loss after 1989 of
$38,180 and tax savings of $19,929. Under the heading "After
Tax Cash Flow Statement" a loss of $3,215 at the end of 1989
is indicated. Also, under the heading "Projected Gain on
Sale of Unit at Various Rates of Appreciation (Assuming a Sale in
1990)" it indicates a profit of $40,197 as the after-tax
cash position on the sale, assuming an appreciation of 8% per
year.
[5]
Mr. Flodder prepared a schedule of rental income and loss
(Exhibit A-3), continuing the builder/vendor's schedule
beyond 1989, and it reflected a positive rental income at the end
of 1996 of $3,041. In fact, in 1996, the actual loss was $4,253.
The issues to be determined are whether the property was acquired
by the Appellant for the purpose of gaining or producing income;
whether the Appellant had a reasonable expectation of profit from
the rental of the property for the years 1995 and 1996; whether
the rental expense were incurred by the Appellant for gaining and
producing income from a business or property; and finally, in the
alternative, whether the disallowed rental expenses were
reasonable in the circumstances. As stated, the Appellant was not
present to testify as to his reasons for purchasing the unit.
[6]
The evidence presented was to the effect that the Appellant
purchased the unit to earn rental income. I find as a fact that
he paid the $131,000 financing down to $66,000 by February 1998
when the property was sold. The Notice of Appeal prepared by
Mr. Flodder included the following which I accept as being
accurate:
By December 31, 1995 approximately 56% of the original debt
with respect to the property had been retired.
By mid 1996, vacancy rates were decreasing and rental rates
were increasing. Many programs initiated by the condominium board
to reduce operating costs were starting to take effect.
Both the condominium board and Dr. Karmali took the steps
necessary to reduce costs and maximize income during this
period.
...
Although the property was sold in February 1998, projections
show the property would have shown profits of $778 in 1998 and
$2,513 in 1999.
[7]
The facts in these appeals are similar to those dealt with by
Bowie J. in von Heymann v. The Queen[1] wherein the taxpayer, a medical
doctor, acquired an interest in a limited partnership which in
turn held an interest in an apartment complex. The acquisition of
such interest was completely financed by borrowed funds. In
assessing the taxpayer, the Minister denied the deduction of his
share of the partnership losses and of interest paid by him on
money borrowed. The Minister took the position that (i) such
interest was not a source of income; (ii) the taxpayer had no
reasonable expectation of profit in view of the very large
financing costs; and (iii) he had participated in the partnership
to obtain tax advantages and not to earn income. While I do not
consider myself bound by this decision, I agree with the
reasoning and adopt that as my own in the present judgment. Bowie
J. said at paragraph 8:
Following the release of the reasons for judgment of the
Federal Court of Appeal in Milewski, I invited written
submissions from counsel as to its application to this case.
Counsel for the Respondent, quite understandably, did not suggest
that the Appellant had failed to meet the "fullness of
time" test established by the Federal Court of Appeal in
Milewski. Instead, he advanced, what I might call, the
secondary argument that the Appellant purchased the unit for
resale and the resale would give rise to a capital gain, not
income.
[8]
Judge Bowie also relied on Stewart v. The Queen.[2] The taxpayer
purchased real estate with a specific intention to resell at a
higher price. It was held that he did not have a source of income
because no rental profit would be realized within the time that
he intended to hold the property and the resale would give rise
to a capital gain and not income. In the present appeals, the
Appellant repaid more than 50% of the mortgage principal and in
the von Heymann appeal, the Appellant had repaid all of
the principal on a $6,000 loan. Bowie J. then went on to quote
Robertson J. in Mohammed v. The Queen[3] and further stated as
follows:
... It does not appear to me that the Appellant in this
case could satisfy that test. (the test set out in
Mohammed). He made no payments on the principal during the
first five years, although his income was considerably in excess
of $200,000 per year.
[9]
The Queen v. Milewski[4] is a more recent decision of the Federal
Court of Appeal. In that case, the Court held that the test was
satisfied because it was reasonable to purchase real estate and
amortize the purchase price over 25 years. Rothstein J. stated at
page 6560:
If there was no indication of any principal repayment or the
annual interest expense results in losses for an indefinite
period of time, i.e., an unusually long amortization period or,
as in Stewart, there was no profit expected over the
intended holding period, there might be no reasonable expectation
of profit. However, those are not the facts here.
Here, the amortization period was 25 years. That is not an
unusual amortization period for long-term investments in real
estate. As the principal is paid down, the interest expense
decreases and, all other things being equal, profitability will
"in the fullness of time" be achieved. The Tax Court
Judge found the investment was long-term in nature. In these
circumstances, I think the reasonable expectation of profit test
was met.
I conclude that the present Appellant satisfied the fullness
of time test as stated in Milewski to establish a
reasonable expectation of profit.
[10] I now
turn to the Respondent's argument that in this case, as in
Stewart, the Appellant purchased the property with the
intention of reselling it at an enhanced price even before it
could become profitable and that the purpose of the acquisition
was not to produce income, but to acquire a capital gain. I
continue with the quote of Judge Bowie in von Heymann:
... the Appellant was motivated in the purchase of his
interest in the partnership by both the possibility of income in
the long run and the possibility of selling the property at a
profit once the real estate market recovered. Counsel for the
Appellant argued that there is strong evidence to support a
finding that the Appellant was engaged in a venture in the nature
of trade in the present case. ... I agree with that view.
See Regal Heights Limited v. M.N.R. Any profit on resale
would, therefore, be on income account.
Judge Bowie then went on to allow the appeals.
[11] In the
present appeals, I find as a fact that the Appellant paid down
more that 50% of the financing before the relevant years. He
purchased it with a joint intention of selling at a profit after
it appreciated over the years, and in the meantime earning rental
income, having paid down the indebtedness. The Minister would
have had a stronger position in the earlier years but chose to
audit the Appellant after more than 10 years of his ownership. By
this time, there is little doubt he had a reasonable expectation
of profit. The accountants projected a profit in 1998, the year
it was sold.
[12] It is to
be noted that Stewart and Allen v. The Queen have
received leave to appeal to the Supreme Court of Canada. The
decisions of the Supreme Court may give us guidance in what has
become somewhat of a complex issue.
[13] For these
reasons, the appeals are allowed and the assessments are referred
back to the Minister for reconsideration and reassessment on the
basis that the Appellant is entitled to the losses claimed as
well as costs, if any.
Signed at Ottawa, Canada, this 24th day of July, 2001.
"C.H. McArthur"
J.T.C.C.
COURT FILE
NO.:
2000-2720(IT)I
STYLE OF
CAUSE:
Mohamed Karmali & Her Majesty the
Queen
PLACE OF
HEARING:
Toronto, Ontario
DATE OF
HEARING:
June 7, 2001
REASONS FOR JUDGMENT BY: The
Honourable Judge C.H. McArthur
DATE OF
JUDGMENT:
June 13, 2001
APPEARANCES:
Agent for the
Appellant:
Richard Rooney
Counsel for the
Respondent:
Suzanne M. Bruce
COUNSEL OF RECORD:
For the
Appellant:
Name:
N/A
Firm:
For the
Respondent:
Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada
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