Joyal J.:-The plaintiff is appealing a decision of the Tax Court of Canada rendered on December 17, 1987, wherein it allowed the defendant’s appeal to the extent that the limitative provisions of subsection 31(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act”) did not apply to the defendant for its 1982 taxation year. The case before this Court now proceeds by way of a trial de novo.
Agreed statement of facts
At the opening of the trial before me, the parties filed an agreed statement of facts which reads as follows:
1. The defendant, Ichi Canada Ltd. ("Ichi") was incorporated on April 4, 1974.
2. Ichi has been in the business of importing and selling equipment for the pulp and paper industry since 1974.
3. Mr. James Thomson owned 80 per cent of the shares of Ichi and his wife,
Heidi, owned the other 20 per cent of the shares.
4. Ichi’s fiscal year-end is April 30.
5. Commencing on June 1981, Ichi purchased thoroughbred and stan- dardbred horses, including a 50 per cent interest in six horses.
6. In or about September 1991, the shareholders of Ichi bought ten acres of farmland located in the municipality of Surrey, B.C., for a purchase price of $220,000.
7. In its return of income for the taxation year ending April 30, 1982, Ichi reported revenue from racing in the amount of $41,154, and deducted horse expenses in the amount of $197,599.
8. In its return of income for the taxation year ending April 30, 1983, Ichi reported revenue from racing in the amount of $26,591, and deducted horse expenses in the amount of $160,859.
9. Commencing in 1983 and continuing into the 1984 calendar year, an audit of Ichi was conducted by Revenue Canada, which resulted in reassessments being issued in respect of Ichi’s 1982 and 1983 taxation years.
10. By notice of reassessment dated August 14, 1984, the Minister of National Revenue (the "Minister") reassessed Ichi for its taxation year ending April 30, 1982, and:
(a) revised Ichi’s farm losses to $182,304; and
(b) restricted Ichi’s farm losses to $5,000 pursuant to subsection 31(1) of the Income Tax Act, on the basis that Ichi had a reasonable expectation of profit from farming, but farming was not its chief source of income.
11. Ichi filed a notice of objection to the reassessment in respect of its 1982 taxation year on November 1, 1984.
12. By notice of reassessment dated December 13, 1985, the Minister allowed an adjustment of interest expense claimed by Ichi in its 1982 taxation year, but made no changes in respect of the disallowed farm loss.
13. Ichi appealed the reassessment to the Tax Court of Canada, and by decision rendered on December 10, 1987, the Tax Court of Canada allowed Ichi’s appeal in respect of its 1982 taxation year, and held that the limitation provision of subsection 31(1) of the Income Tax Act did not apply to Ichi.
14. By statement of claim filed April 27, 1988, the Crown appealed the decision of the Tax Court of Canada to the Federal Court-Trial Division pursuant to subsection 172(1) of the Income Tax Act.
The law
The relevant provisions of the statute are as follows:
31(1) Where a taxpayer’s chief source of income for a taxation year is neither farming nor a combination of farming and some other source of income, for the purposes of sections 3 and 111 his loss, if any, for the year from all farming businesses carried on by him shall be deemed to be aggregate of
(a) the lesser of
(i) the amount by which the aggregate of his losses for the year, determined without reference to this section and before making any deductions in respect of expenditures described in section 37, from all farming businesses carried on by him exceeds the aggregate of his incomes for the year, so determined from all such businesses, and
(ii) $2,500 plus the lesser of
(A) 1/2 the amount by which the amount determined under subparagraph (i) exceeds $2,500, and
(B) $2,500, and
(b) the amount, if any, by which
(i) the amount that would be determined under subparagraph (a)(i) if it were read as though the words "and before making any deductions in respect of expenditures described in section 37" were deleted, exceeds
(11) the amount determined under subparagraph (a)(i)
and for the purposes of this Act the amount, if any, by which the amount determined under subparagraph (a)(i) exceeds the amount determined under subparagraph (a)(ii) is the taxpayer’s "restricted farm loss" for the year.
That section, in its earlier manifestation as subsection 13(1), was described by Dickson J., as he then was, in the often quoted Moldowan v. The Queen, [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213, as awkwardly worded and intractable. He decided to apply his structural and analytical talents to bring order and clarity to it. The result was a categorization of all taxpayers involved in farming operations, as follows:
(1) Taxpayers for whom farming could reasonably be expected to provide the bulk of their income or the core of their work routine. Such taxpayers are not confined by subsection 31(1) and may deduct the full amount of their farm losses from their other income.
(2) Taxpayers for whom farming can be regarded as a sideline business, providing only a less than significant portion of their income. These taxpayers’ allowable farm losses are restricted by the formula set out in subsection 31(1) which limits losses deductible to a maximum of $5,000. (This amount has now been increased to a maximum of $8,750, S.C. 1988, c. 55, subsection 16(1 ).)
(3) Taxpayers for whom farming is simply a diversion or hobby, but whose activities fall short of being capable of characterization as a career. These individuals are prohibited under the Act from deducting any of their farming losses from their income. These are considered non-business losses and are treated as personal living expenses subject to paragraph 18( 1 )(h) of the Act.
Emphasizing that the fit of any taxpayer into any one of the three categories was dependent upon the facts of each particular case, Dickson J. set some guidelines to which the trier of these facts should direct his or her mind. These might be summarized as follows:
1. Before farming can be a source of income, the operation must realize a profit or have a reasonable expectation of profit; in other words, it must be conducted as a business.
2. Such a determination is an objective one to be made from all the surrounding facts and circumstances.
3. The objective criteria to be considered are the profit and loss experience in past years, the taxpayer’s training, the taxpayer’s course of action and the capability of the venture as capitalized to show a profit after charging capital cost allowance.
Dickson J. was quick to point out that these criteria were by no means exhaustive. As well, he said that in analyzing income sources, the "chief source of income" is both an objective and a relative test. It is decidedly not, he said, a pure quantum measurement.
Since Moldowan, supra, there has grown an exhaustive, nay exhausting, accumulation of jurisprudence where subsection 31(1) is the basis of an assessment. Obviously, the section only comes into play when the taxpayer suffers a loss or a series of losses, thereby prompting the Crown to react by way of reassessment and either limiting the taxpayer’s loss deductions or eliminating them altogether.
In the event, subsection 31(1) cases have substantially run on a finding that the farm operations were not businesses run "for profit or with a reasonable expectation of profit". In this connection, the noted tax author Vern Krishna elaborated on this in the May 8-14, 1995, issue of Law Times in an article entitled "Revenue Canada Looks for Real Profit Motivation". He lists the following considerations:
1. The extent of time devoted to the endeavour;
2. financial capitalization of the venture in the context of the normal requirements of similar businesses;
3. the industry norm for profitability in similar businesses;
4. the extent to which the taxpayer acts as others would who are engaged in similar businesses;
5. the amount of time devoted to promoting and marketing the taxpayer’s work; and
6. the amount of revenue received as a result of sales or services provided by the taxpayer.
Review of the facts
Now, all of these elements being considered, the issue lies in raising the material facts and drawing conclusions from them.
The taxpayer company is totally owned by James Mervin Thomson and his spouse Heidi Thomson. The company was incorporated in 1974 when it was in the process of developing a market for paper-roll covering fabrics in the pulp and paper industry. These products represented state of the art Japanese technology. As a result, the company prospered and produced handsome returns.
In December 1979, however, the taxpayer was given notice by his Japanese supplier that the distributorship agreement was to be terminated in July 1980, although all orders up to July 1981 would be honoured.
For some time, the company had of course been running itself. In the spring of 1981, anticipating the downward effects of the loss of its principal source of income, the company decided to change direction.
The new direction, under the guidance of Mr. Thomson, was farming. The owner had not only studied silviculture and hydroponic methods while attending college, he had acquired considerable horse racing and horse- breeding experience attending thoroughbred and standardbred racing events in B.C. and elsewhere. Mr. Thomson was satisfied that with his knowledge of the business, together with his management skills and his experience in buying and selling, his company could make a go of it.
The company first of all bought a ten-acre farm on designated agricultural land in Surrey, B.C., for the sum of $220,000. A house was located on the property and the idea was to use the house as a residence for the company manager and horse trainer.
Among other plans were the clearing of bushland at the back of the property and construction of horse stables holding some 30 stalls. In this respect, Mr. Thomson called for bids from construction groups and even developed his own design for an oblong or circular stable which appeared to have innovative features.
From Mr. Thomson’s evidence, a multi-pronged approach to the company’s operations was envisaged. This included the stabling of some 30 horses, which would yield an income of some $120,000 annually. There was also the matter of purchasing some 16 horses in the first year of operations, at a cost of some $147,000. These were given to the care of trainers and handlers and were run in various racing meets. Following consultations with horsebreeders, racehorse owners and the government horse racing commission, Mr. Thomson directed his energies fairly exclusively to the company’s new operations. He would be in attendance at the track from 5:30-6:30 a.m. onwards, looking after his horses, consulting with trainers and continually in the market for the sale, purchase or exchange of horses, and entering the more promising ones in races. The conduct of the taxpayer’s other business required very little time and what time was spent by Mr. Thomson at the taxpayer’s office was accountable to both operations.
Mr. Thomson testified that a half million dollars was expected to be the company’s total investment. The bulk of the expenses consisted of land and house at $220,000, the cost of horses at some $140,000 and the cost of stables at $150,000.
In the year under review, namely 1982, the company reported income of $41,000 from its farm operations against expenses of $223,000-for a net loss of some $182,000.
It is on record that in 1983, smaller but still considerable losses were experienced by the horse-farming operations, but the tax treatment of the losses is not at issue before me. What is interesting, however, is that the construction of stables was not carried out. This meant that either the taxpayer would have earned income of some $120,000 for taking care of other people’s horses, or the cost of stabling its own horses would have been considerably reduced. By that time, however, according to Mr. Thomson, Revenue Canada was in the process of auditing all of the company’s operations and had told the taxpayer that the deductibility of the company’s farm losses was a matter of grave concern. Understandably, this had a most unsettling and chilling effect upon the taxpayer; the planned construction of the stables was put on hold.
General observations
As will be noted, we are dealing here with a reassessment in 1984, a decision of the Tax Court of Canada in 1987 and a trial de novo in 1995. It is an unusually long time for the processing of the reassessment to the Federal Court level.
Yet that comment in no way indicates that the relevant evidence existing in 1984 has evolved or tarnished since that time. In effect, the evidence before me would appear to be substantially that of which Kempo J. was seized in 1987.
Another comment which I consider appropriate is that the reassessment under review is for the year 1982, which is the first year of the taxpayer’s involvement in its horsebreeding and horse racing operation. To the extent that one of the tests outlined in Moldowan, supra, is one of reasonable expectation of profit, it is somewhat perplexing or questionable to reach any conclusion in that respect when the operations have barely got off the ground.
Finally, in analyzing any evidence relating to farming operations pursuant to subsection 31(1) of the Income Tax Act and which is always coloured by the taxpayer’s somewhat self-serving intentions, a Court must be reminded that the deductibility of any resulting losses from other income do not provide the taxpayer with a free ride. Assuming a tax rate of 30 to 50 per cent, the remainder nevertheless represents a substantial net loss and a taxpayer’s net worth is reduced accordingly.
Findings
In spite of the Crown’s strong argument to have the Court endorse its assumptions under which the 1982 reassessment was issued, I am satisfied that for that year, the assumptions have been successfully rebutted by the
taxpayer and that the Crown’s appeal should be dismissed.
First of all, I am in substantial agreement with the findings of Kempo J. in her Tax Court of Canada decision dated December 10, 1987. Kempo J. relied upon some of the indicia outlined in Moldowan, supra, with respect to the amount of money expended on the farming operations, the experience and business acumen which the taxpayer’s owners could bring to the operations, the amount of time and effort devoted in the overall planning of the venture and in its operations during the 1982 taxation year.
As I have mentioned earlier in these reasons, the availability of deductions from other sources of income to offset new venture losses in no way provides a taxpayer with a free ride. As far as the value of an entrepreneurial venture is concerned, the possibility of offsetting losses from other income might very well limit the risk involved, but it does not eliminate it. I appreciate that this rationalization of the taxpayer’s position does not provide a definitive answer to the application of a subsection 31(1) assessment, but it certainly gives weight to the stated intention and purpose of the taxpayer to make money on its venture and not to lose money on it.
Furthermore, applying subsection 31(1) with respect to the first year’s operation is like cutting a horse off at the pass—it overlooks the element of Start-up costs which Dickson J. referred to in Moldowan, supra.
I should also traverse the Crown’s argument that the requirement of a new direction in the taxpayer’s usual business has not been met. The Crown relies on a judgment of my colleague Teitelbaum J. in Buchanan Forest Products v. The Queen, [1986] 2 C.T.C. 7, 86 D.T.C. 6282, where at page 19 (D.T.C. 6292), he stated that although the Moldowan rules apply to a corporation, strong proof of change in its corporate structure is required to establish that its centre of activity is being changed.
I have no particular quarrel with Teitelbaum J. in light of the circumstances of that case. I can only suggest that in the case before me, the taxpayer is the buyer and seller of pulp and paper equipment, it is run as a one-man show, it has very limited fixed assets and can be administered by a staff of three or four. Its main asset is goodwill, 1.e., its ability to maintain its distributorship with its Japanese supplier. As the evidence discloses, notice of termination of that arrangement was sufficient for the company to focus its mind on a change in its centre of activity.
The very nature of the "paper” operations historically attached to the kind of business in which the taxpayer was engaged, i.e., buying its equipment on order and maintaining only nominal inventory, brings into sharper focus the criterion of capital invested. From the point of view of liquid assets, the taxpayer’s investment exceeded considerably the tangible assets it possessed. Its commitment to put that kind of money into the farming venture is certainly indicative of a new direction, which new direction is, in my respectful view, neither by reason of whim nor for purposes of riding to hounds on weekends.
It is noted that one of the Crown’s assumptions was that the defendant’s chief source of income was not farming. I am not too clear as to whether this issue raises a new point of legal interpretation or not. If it does, I fail to see where much credence may be given to it. In my view, it seems to go against the realities of any new venture involving farming. Depending on the nature of the contemplated operations, initial investments-or start-up costs, as Dickson J. calls them in Moldowan, supra-can reasonably result in early losses.
Furthermore, subsection 31(1) has long been interpreted in the light of market conditions where a new operation by a taxpayer might not necessarily constitute the taxpayer’s chief source of income, so long, of course, as the new operation meets the test of reasonable expectation of profit. If subsection 31(1) be interpreted as imposing a ’’chief source of income from farming” at the initial stage, I doubt that anyone enjoying income from other sources would ever get out of the starting gate, as it were. The situation, in my respectful view, would go far beyond the intention of Parliament in either restricting the amount of farm losses or disallowing them altogether.
By allowing the taxpayer a $5,000 or $8,700 deduction, thus putting the person in the second category of persons engaged in farming, is the Crown pre-empting any challenge by a taxpayer who is entering a new activity and in relation thereto, might not be expected to make of it in its first year a chief source of income? In my view, such would be the consequence of the Crown’s interpretation. If such were Parliament’s intention, it could simply have ruled that farming losses are only allowed to farmers whose source of income is exclusively farming. Yet, as Dickson J. pointed out, what happens if such a farmer comes into an inheritance or wins a sweepstake?
It seems to me that, in any event, the Crown itself has interpreted the statute in a manner to express clearly the intention of Parliament, which is to limit the gentleman farmer’s losses, the excess being presumed by law to be lifestyle expenses. There has been recognition, however, of the situation of a taxpayer who engages in farming with the intention of making of it his or her principal occupation and who has to depend on other sources of income to get the operation on the road. From the time that money will be put into the venture, some delays in developing a profitable operation will occur. The spread of losses over more than one taxation year might depend on extraneous forces, 1.e., an unexpected drop in the market for beef, or loss of an entire herd through disease. The spread might also depend on how carefully Revenue Canada monitors the taxpayer’s tax returns where farm losses are claimed. In either event, it is fair to say that subsection 31(1) assessments are usually issued when deficit performance can be measured objectively and without regard to the more subjective intentions advanced by the taxpayer. In such situations, Courts have ruled more often than not that the taxpayer does not meet the reasonable expectation of profit test.
Conclusions
As stated by Vern Krishna in the article which I referred to earlier,
The profit motive test is crucial to the integrity of the tax system. It draws the line between providing limitless tax subsidies for personal pursuits with minimal economic flavour and economic enterprises conducted on a commercial basis for profit. It distinguishes the idiosyncratic collector and hobbyist from the entrepreneur. Taxpayers cannot expect other taxpayers to subsidize their personal hobbies.
The author went on to say:
On the other hand, the legal test should not be so stringent as to discourage valid entrepreneurial activities. Risk taking is to be encouraged if society is to prosper. Thus, the test is: Did the taxpayer have a reasonable expectation of profit? The test is not whether the expectation was of reasonable profits.
I have considered several of the cases of farm losses referred to me by counsel for the parties. Many of these cases have similar factual backgrounds, but counsel are well aware that none of them are identical. As so often stated, each case is a sui generis one to be decided on the basis of its own individual or discrete facts.
Although most subsection 31(1) appeals may be regarded as borderline cases, I must nevertheless in this case confirm my view that the taxpayer has rebutted the Crown’s assumptions and that on the basis of the tests set out in Moldowan ,supra, its losses for the year 1982 should be allowed. I might list among these tests the circumstances in the taxpayer’s business which provoked it to take a new direction, the experience of its principal owner in bringing to it his management skills, the knowledge he acquired in the business of horsebreeding and horse racing, the amount of time and effort devoted to its development, the amount of capital expended during the year in question and the amount of revenue which the venture yielded in its first year of operation.
I should therefore dismiss the Crown’s appeal with costs.
Appeal dismissed.
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