Gustav A. Panz v. Minister of National Revenue, [1991] 1 CTC 2459, 91 DTC 125

Sobier, T.C.J.:—This is an appeal by the appellant, Gustav A. Panz, with respect to his 1984, 1985 and 1986 taxation years whereby the Minister of National Revenue disallowed business losses of $34,059, $8,061 and $1,962 respectively.

The issues were succinctly stated by counsel for the appellant in her opening statement and her opening of argument. They are as follows:

(1) In his venture did the appellant have a reasonable expectation of profit?

(2) Were the expenses claimed personal expenses of the appellant? and

(3) Were the expenses incurred for the purpose of earning income?

In 1981, the appellant purchased a condominium unit in Palm Springs, California for $135,077. He paid $31,077 cash and financed $104,000 or about 75 per cent of the purchase price, originally with interest payable at the rate of 17.5 per cent per annum.

The unit was offered for sale on the basis that it would be pooled and operated along with other units purchased by others as a Hotel known as "Noel Place”. Included in the material filed by the appellant was a document dated July 1981 entitled ” Noel Developments Ltd. Final Confidential Circular to Clients". On the first page, there is a summary which reads as follows:

Circular to Clients

Noel Developments Ltd. has been looking for just the right kind of investment to recommend to its clients. The needs of its clients are as follows:

1. An investment that offers a high quality of construction at a favourable price; 2. A tax shelter investment with a good ratio of soft cost to overall cost;

3. A project which has reasonable access to Vancouver and thus offers the possibility of personal use;

4. A unit which has potential for rental even if potential is small;

5. A project which offers a favourable financing package.

Noel is pleased to advise its clients that it believes it has found such a project and has finalized negotiations on their behalf.

This package is available exclusively to Noel's clients.

This circular describes the project and the negotiated package available to Noel's clients.

Under the heading Rental, the circular states:

Noel believes the investment makes sense even without any revenue, and recommends that clients base their decisions regarding this investment on the assumption that there will be no rental revenue in either option.

Noel, however, will endeavour to promote the rental of these units in every possible way. To this end, Noel has negotiated with C.F. Air a joint-promotion program . . .

In essence, C.F. Air Holidays, a subsidiary of C.F. Air, has offered to use our development as their leading luxury-level condominium package for the next season starting in November and ending in May. C.F. Air is pleased with the response to their Palm Springs programme and will run two direct flights weekly from Vancouver and one from Calgary.

The appellant was familiar with the Palm Springs area. He took advice from a Mr. Laxton who stated that it was a "good deal”. He advised the appellant to purchase a unit and put it into the hotel complex.

The appellant, referring to the assumption in the circular that there would be no rental income still believed it a good investment. He also had advice from Deloitte Haskins & Sells who also said it was a good investment with profits in the future. Mr. Panz did not expect an immediate profit but expected one within several years.

Many letters and documents including a brochure setting forth the apparently business-like manner in which Noel Place was to be operated were introduced in evidence. There was correspondence from C.P. Air Holidays, Pacific Western Holidays, Budget Rent-a-Car, Holiday House-The Travel People, dealing with rentals and services. There was a copy of an advertisement to be placed in a magazine called "Palm Springs Life". There were examples of reservation requests and confirmations. On the whole, a great deal of effort apparently went into promoting Noel Place as a luxury private villa accommodation.

Evidence was given concerning payment of U.S. federal withholding tax for employees, payment of Palm Springs Transient Occupancy Tax and other details clearly indicating that Noel Place was a hotel operation.

Rules were formulated dealing with the personal use of the units by owners. They were permitted only two weeks in the peak periods between December 15 and May 15. If the owners wished to use the unit in excess of two weeks during the peak period, they were required to pay the full peak period rate.

At the outset in 1981, there were approximately 80 unit owners who placed their units into Noel Place. Subsequently, this number was drastically reduced.

Mr. Panz stated that by the years 1982 and 1983 there was a recession; the Canadian dollar was low compared to the U.S. dollar, interest rates were about 17.5 per cent and expenses, including interest, were payable in U.S. funds. Owners’ costs were increased by 35 to 40 per cent. Because of this, owners were actually “ walking away” from units. Some owners tried to pull their units out of the Noel Place operation and they were warned against doing so since some of these units were committed to guests who would have to be accommodated elsewhere.

Owners continued to leave and the appellant became increasingly discouraged by the low rental income and the high overheads. In July 1984, he became a member of the Board of Directors of Noel Place and was a leader in trying to reduce costs. When he came on the scene, Noel Place had outstanding indebtedness of U.S. $140,000.

Mr. Ranz then took over management. What he faced was disruption in essential services such as gas, water and power; liens were placed on the property and only about 20 to 25 unit holders remained. Mr. Ranz found bad management, high costs and stated that "someone was having a good time on my investment”. Through his efforts, creditors were placated, services restored and the U.S. $140,000 of debt was paid off from current earnings.

On April 30, 1985, the joint venture was dissolved. Being free from the joint venture, the appellant sought out leasing opportunities and stated that his losses for 1985 and 1986 were decreasing and in 1987 a profit was made. This will be dealt with later in these reasons.

Mr. Panz gave evidence as to his personal use of the unit. He used it for only two weeks in the peak period and in November. It is clear that Mr. Panz did not use the unit a great deal for his own personal use.

Although the years under appeal were 1984 to 1986 inclusive, in cross- examination it was pointed out that Mr. Panz claimed losses between 1981 and 1986 totalling approximately $180,000. After one year, he felt that the operation was not well managed. Although there was a loss in 1981, he could not recall the amount. However, he stated that 1982 appeared to be a better year. From 1981 to 1984, there was an accumulated deficit for the Noel Place operation of $65,501. In 1983, Mr. Ranz renegotiated the mortgage interest rate down to 13 per cent from 17.5 per cent.

Over and above his share of the joint venture losses and profits, in 1984, Mr. Ranz also claimed his own expenses, including interest expense of $14,250, property taxes of $1,574, association fees of $2,928 and other expenses in all totalling $26,464 before any provision for capital cost allowance.

In 1985, gross rental income for January and February was $1,558 and expenses totalled $3,725 for a net loss for the two months of $2,167 again before any provision for capital cost allowance. For the remaining months of 1985, there was gross rental income of $2,977 and expenses of $8,871 for a loss of $5,894 before any provision for capital cost allowance. No capital cost allowance was in fact taken. If it were, the loss would have been approximately $12,900. At this point, Mr. Panz was only claiming about 1/3 of the actual expenses. He said he did this because of increased personal use and on the advice of his accountants. However, there was some evidence that he only rented during the peak period of four months, although it would appear to have been more business-like to increase revenue since many costs were fixed.

In 1986, gross rental income was $8,221 and expenses before capital cost allowance of $10,183. Again, expenses claimed were 1/3 of actual expenses. The loss before capital cost allowance was $ 1,962 and if capital cost allowance of approximately $7,000 was taken, the loss would have been approximately $9,000.

In 1987, gross rental income was $10,151.90 and there were expenses before capital cost allowance of $9,227.71, showing an apparent profit of $924.19. The expenses claimed were again only 1/3 of actual expenses and if capital cost allowance of approximately $7,000 had been taken, the loss would have been of approximately $6,000.

In 1988, gross rental income was $10,771.20 and there were expenses before capital cost allowance of $10,251, showing an apparent profit of $521.20. In 1988, again only 1/3 of actual expenses were claimed and no capital cost allowance was claimed. If the same capital cost allowance had been taken, the profit of $521.20 would have been a loss of approximately $6,500.

Having seen the magnitude of the losses even when claiming only about one-third of actual expenses and no capital cost allowance, the issue surely is: Did the appellant have a reasonable expectation of profit?

The appellant's evidence was that he purchased the unit in order to pool it with others and earn rental income.

The Confidential Circular to Clients referred to above stated that Noel Developments Ltd. believed the investment made sense even without any revenue and that clients should base their investment decisions on the basis that there would be no rental revenue. The circular also stated that a unit had potential for rental even if the potential was small. Counsel for the appellant argued that these statements were merely a disclaimer or worst-case scenario to protect Noel Developments Ltd. should there be insufficient or no income. The units were not being sold as rent-producing properties. However, that is not to say that the appellant did not purchase his unit as an income producing property. One must look at the facts in order to determine that issue.

The hotel operation had all of the indicia of being a business. However, it is not the profitability or expectation of profit of the business that is in question, but whether the appellant had a reasonable expectation of profit from renting his unit. At the outset, with interest at 17.5 per cent per annum together with other fixed costs, a great deal more income was needed than was ever produced in order to even break even. After reducing the interest rate to 13 per cent per annum and claiming approximately 1/3 of the other expenses, there were still losses. These losses were incurred prior to any provision for capital cost allowance.

As to the meaning of reasonable expectation of profit, the leading case is Moldowan v. The Queen, [1977] C.T.C. 310; 77 D.T.C. 5213 (S.C.C.). At page 313 (D.T.C. 5215), Dickson, J. (as he then was) stated:

Although originally disputed, it is now accepted that in order to have a" source of income" the taxpayer must have a profit or a reasonable expectation of profit. Source of income, thus, is an equivalent term to business: Dorfman v MNR, [1972] CTC 151; 72 DTC 6131. See also paragraph 139 (1)(ae), of the Income Tax Act which includes as “personal and living expenses and therefore not deductible for tax purposes, the expenses of properties maintained by the taxpayer for his own use and benefit, and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit. If the taxpayer in operating his farm is merely indulging in a hobby, with no reasonable expectation of profit, he is disentitled to claim any deduction at all in respect of expenses incurred.

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. 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, the capability of the venture as capitalized to show a profit after charging capital cost allowance.

Going through all the years prior to and after the years under appeal there was no profit if capital cost allowance had been taken.

Counsel for the appellant referred to McNeill v. The Queen, [1989] 2 C.T.C. 310; 89 D.T.C. 5516. She referred to the fact that there were unforseen circum- stances such as bad management and bad economic climate which reduced the ability of the operation to be profitable. The interest rate at the beginning was 17.5 per cent and that was known to the appellant. Some other costs were known. It was the revenue side that was unknown. It was clear from the circular that revenue was going to be very small at best and therefore not sufficient to cover expenses and this proved to be the case. During the years under appeal, the interest rate had in fact been reduced to 13 per cent and still there was no profit.

In Laurence v. M.N.R., [1987] 1 C.T.C. 2234; 87 D.T.C. 173 (T.C.C.), His Honour Judge Sarchuk stated at page 2237 (D.T.C. 175) as follows:

Looking at all the figures presented for each of the four taxation years in question and viewing the capability of the condominium as capitalized to show a profit I cannot find any reasonable expectation of profit. It is illogical to suggest that there can be a source of income within the meaning of the Income Tax Act if the maximum possible profit that can be expected does not cover the necessary expenses of operating it particularly where it appears that the situation is not likely to change in the foreseeable future.

Counsel also referred to Mullen v. M.N.R., [1990] 2 C.T.C. 2141; 90 D.T.C. 1551 (T.C.C.). Dealing with the issue of expense not producing income, counsel referred to page 2146 (D.T.C. 1555) of Judge Brulé’s reasons where he wrote:

It is not necessary to show that expenditures actually resulted in income and this was set out in the case of Royal Trust Company v. M.N.R., [1956-60] Ex. C.R. 70; [1957] C.T.C. 32; 57 D.T.C. 1055, wherein the Court at page 1062 sets out the following:

The essential limitation in the exception expressed in section 12(1)(a) [now 18(1)(a)] is that the outlay or expense should have been made by the taxpayer ‘for the purpose' of gaining or producing income'from the business'. It is the purpose of the outlay or expense that is emphasized but the purpose must be that of gaining or producing income'from the business’ in which the taxpayer is engaged. If these conditions are met the fact that there may be no resulting income does not prevent the deductibility of the amount of the outlay or expense. Thus, in a case under the Income Tax Act if an outlay or expense is made or incurred by a taxpayer in accordance with the principles of commercial trading or accepted business practice and it is made or incurred for the purpose of gaining or producing income from his business its amount is deductible for income tax purposes.

Judge Brulé found that the justification for the condominium expense was that the condominium was used to develop business. There is no such justification in this case.

The Court finds that from the outset, expenses far outdistanced revenue, even potential revenue; the unit was capitalized with high interest bearing debt and no profit could have been made if capital cost allowance was taken.

Based upon the evidence, the appellant has failed to discharge the onus placed upon him to establish that ne had a reasonable expectation of profit from the property in the years under appeal, that the expenditures made were for the purpose of earning income and that they were not personal expenses.

Accordingly, the appeal is dismissed.

Appeal dismissed.