Urquhart v. R., [1996] 2 CTC 2532 (Informal Procedure)

Sobier J.T.C.C.: —

These appeals were heard under the informal procedure of this Court.

The Appellant appeals from the assessments by the Minister of National Revenue (the “Minister”) for her 1985, 1986, 1987 and 1988 taxation years, whereby in each year the Minister allowed the Appellant’s farm losses only in accordance with subsection 31(1) of the Income Tax Act (the “Act”).

The Appellant carried on a horse breeding and racing operation from a property owned by John Valentine, the person with whom she lives. According to the Appellant, when the farm was acquired, it needed considerable work to upgrade it to a position where it was viable for carrying on her operation.

Although she considered the breeding portion of the operation to be the more important, she did earn income from racing her own horses as well; however, on the whole she did not appear to put much emphasis on the racing side.

It became clear that she worked long and hard hours and although she received income from consulting with John Valentine Enterprises Ltd., this consulting did not involve a significant amount of her time. Her consulting agreement required her to be available for only up to 50 hours per month, leaving the balance of her time to horse breeding. Her whole interest and the bulk of her time and energy was geared to the operation.

The tests of Dickson, J. as he then was, in Mo Ido wan v. R., [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213, especially those parts which deal with the “reasonable expectation of profit” have been examined and applied by the Courts on many occasions.

At page 485 (C.T.C. 313, D.T.C. 5215) of Moldowan (supra), Mr. Justice Dickson 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. Minister of National Revenue, [1972] C.T.C. 151, 72 D.T.C. 6131. See also s. 139(l)(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. The list is not intended to be exhaustive. The factors will differ with the nature and extent of the undertaking: The Queen v. Matthews (1974), 28 D.T.C. 6193. One would not expect a farmer who purchased a productive going operation to suffer the same start-up losses as the man who begins a tree farm on raw land.

This passage, the statutory provisions of the Act as well as other case law, were recently canvassed by Linden, J.A. of the Federal Court of Appeal in Tonn v. R., [1996] 1 C.T.C. 205, 96 D.T.C. 6001. In that case, the Appellant Enno Tonn, purchased a vacant residential property in Scarborough, Ontario for $245,000. He assumed an existing first mortgage of $168,000, bearing interest at 11.25 per cent per annum. This mortgage was supplemented by a first mortgage of $50,000 on Mr. Tonn’s principal residence, with interest at the rate of 12.5 per cent per annum. The balance was borrowed on an interest free loan from the Appellant, Lester Sinanansingh.

Mr. Tonn expected to rent the property for $1900 per month through 1990 and thereafter, the rent would increase by six per cent per annum. He believed this was a good investment, both for current income and capital appreciation.

Things did not work out as he had planned and profits did not materialize for the years in question. Mr. Tonn took steps to lower the interest cost by discharging the $50,000 mortgage on his home. His wife, the Appellant Rose Tonn, joined in the venture to ease the financial stress and the Appellant, Mr. Sinanansingh, converted his loan into a one-third equity interest in the property.

The Appellants deducted losses from other income, which losses in due course, were disallowed by the Minister.

The Appellants’ appeals were dismissed by the Tax Court of Canada and the Appellants brought an application under section 28 of the Federal Court Act for a judicial review of that decision.

Linden, J.A. carried out an extensive review of business expense deductibility, including a lengthy discussion of the various provisions of the Act which are applicable, including subsection 9(1), paragraphs 18(1)(a) and (h), as well as subparagraph 20(1 )(c)(i), as it deals with the deductibility of interest expenses.

Against this background, he then considered what he described as the common law Moldowan test, which requires a profit or reasonable expectation of profit.

In brief, Linden, J.A. considered that this test is not to be made solely in hindsight without examining the business aspects of the investment. He pointed out that in Moldowan, one of the primary questions was whether there was a real business or whether the expenditures were of a personal nature.

That is not to say that what was done in Tonn was to merely differentiate between general expenses and personal expenses. He went on to say, at page 218 (D.T.C. 6009), as follows:

Whatever the particular circumstances, transactions contrary to the purposes of the Act are generally those where the underlying aim is inappropriate tax avoidance. The attempt to deduct the costs of what are essentially hobby or personal expenses as a business expense is one good example. As common sense might suggest, the Act’s fundamental purposes are not easily construed as contemplating such tax avoidance. It is, I believe, in this spirit that Dickson J. penned the Moldowan test.

I have dwelt upon the issue of the origin of the “reasonable expectation of profit” test because a proper understanding of it is necessary to the resolution of this application. As a common law, formulation respecting the purposes of the Act, the Moldowan test is ideally suited to situations where a taxpayer is attempting to avoid tax liability by an inappropriate structuring of his or her affairs. One such situation is the attempted deduction of an expense incurred to gain a tax refund. Another is an attempt by a taxpayer to deduct personal housing expenses under the guise of a free-lance typing business operated by his wife. These cases are merely instances where an inappropriate use of the Act is attempted, and where the Moldowan test has rightly denied deductibility on the basis that the Act’s purposes would otherwise be violated.

But do the Act’s purposes suggest that deductions of losses from bona fide businesses be disallowed solely because the taxpayer made a bad judgment call? I do not think so. The tax system has every interest in investigating the bona fides of a taxpayer’s dealings in certain situations, but it should not discourage, or penalize, honest but erroneous business decisions. The tax system does not tax on the basis of a taxpayer’s business acumen, with deductions extended to the wise and withheld from the foolish. Rather, the Act taxes on the basis of the economic situation of the taxpayer — as it is in fact, and not as it should be, subject to what is said below.

The Appellant reported the following farm losses:

It is clear from Tonn that the business aspect of a venture should be looked at subjectively when determining whether there was a reasonable expectation of profit from the venture. However, is hard work and time spent enough to warrant the deductibility of the losses? There comes a point when one must say, notwithstanding the opening apparently made by Tonn, that what the Appellant was engaged in was a pious hope of earning a profit. If objectivity is not the main building block on which to say whether there was a reasonable expectation of profit, surely subjective beliefs alone cannot be used to allow a taxpayer deductibility where that subjective belief cannot stand the cruel light of the facts. And the facts here are that no matter what the Appellant’s beliefs were, the operation was unable to become profitable.

Not only did the Appellant not show actual profitability, but failed to demonstrate any potential for profitability. No evidence was shown by which the Appellant changed her course to attempt to rectify the matter. The losses continued.

As Décary J.A. said in Landry v. R. (sub nom. Landry v. Canada), [1995] 2 C.T.C. 3, 94 D.T.C. 6624 (F.C.A.) leave to appeal to S.C.C. refused (sub nom. Landry v. Minister of National Revenue), 187 N.R. 237n (S.C.C.), application for reconsideration of leave to appeal to Supreme Court refused (February 8, 1996) Doc. 24370 (S.C.C.) 94 D.T.C. 6624 (F.C.A.) at page 6 (D.T.C. 6625):

There comes a time in the life of any business operating at a deficit when the Minister must be able to determine objectively, after giving someone a head start for a number of years, as the case may be, that a reasonable expectation of profit has turned into an impossible dream.

I adopt those comments as being particularly appropriate to these appeals. Therefore, the appeals are dismissed. Appeal dismissed.