Golden Estates Limited v. Her Majesty the Queen, [1994] 2 CTC 2084, 94 DTC 1441

Kempo, J.T.C.C.:— These general procedure appeals concern the appellant’s 1987 and 1988 taxation years ending January 31, 1987 and January 31, 1988, respectively.

The sole issue was to categorize the gains of $525,913 for 1987 and the gains of $179,237 for 1988 arising out of the sales over these two years of 25 housing units located on a subdivision called Belleview Park in North Bay, Ontario. The re- spondent, acting through the Minister of National Revenue (the "Minister") assessed these gains on account of income while the appellant maintains they are assessable on account of capital.

For the appellant it was submitted that while the law is to characterize the gains realized on the sale of rental property by a builder/developer who builds to sell and to rent as income, the appellant’s circumstances here are such that the gains in issue can and should be characterized on account of capital. Stripped to their essence, the circumstances are that the appellant was created as an estate vehicle to build wealth for the children of its key man, Mr. Frank Orsi, its original intent was to commit a finite number of units for rental use which was realized through its considerable rental stock and substantive rental income, and that the sales in issue were motivated primarily by the desire to fund a new rental project which amounted to a transformation of the rental character of the 25 properties into rental projects that were more lucrative.

General background facts

The appellant, Golden Estates Ltd. ("Golden"), was incorporated on April 22, 1974, its sole shareholders and officers being the three children of Mr. Frank Orsi ("Mr. Orsi"). It was common ground between the parties to these appeals that Mr. Orsi, while neither an officer nor employee, ran all of Golden's affairs and made all of its decisions. That this was so was corroborated by all of the appellant's witnesses, more particularly its rentals manager, Ms. Jeanne Koselek, its in-house accountant, Bill Huggett, and its president Angela Orsi (Mr. Orsi’s daughter) who deferred to all of Mr. Orsi’s decisions respecting the acquisition, development and housing construction upon the lots located in Golden's Belleview Park subdivision (“Belleview”). No written development plans were prepared and followed; these matters were said to have evolved out of Mr. Orsi’s head and occurred when he said so. Examples of this included when a vacant lot would be sold to another builder, when a building permit would be taken out, when construction would commence on each housing unit, to what stage and when it would be completed, when and which housing unit would be listed for sale and with whom, and which units would be rented, rented with option to purchase, or sold. Mr. Orsi also determined all matters of financing, guarantees, and purchases of other properties for residential development.

Mr. Orsi testified that Golden was incorporated as an estate vehicle for the benefit of his three children so that they would have some assets and revenues therefrom for their future. This desire for his children arose from his own personal background.

Mr. Orsi arrived in Canada from Italy in 1949 as a young man. He was without money or trade skills and could not speak English. After working as a bricklayer he became involved in bricklaying contracting and from there began to buy, build and sell houses in various southern Ontario locations. He has worked long and hard. Through a variety of corporate vehicles, he has built at least 500-600 semidetached and single houses, over 150 townhouses and a number of apartment complexes. The evidence was that currently his three children through their own corporate vehicles own a total of 432 rental units between them housing approximately 2,000 tenants which represents around ten per cent of North Bay’s rental population.

Angela Orsi testified that Golden was planned by her father to be an estate vehicle for his three children and that today he has been very successful in creating a large and tangible asset base for them.

The Belleview Park subdivision ("Belleview")

This property was acquired by Golden in late 1974 or early 1975. They subdivided the land into 58 lots designated for 116 semi-detached houses (hereat- ter sometimes called a "semi") and 160 lots designated for single family homes (hereafter sometimes called a "single"). Other areas within Belleview were designated for townhouse developments.

Construction of housing units began in 1975 with the building and sale of eight singles on Cartier Street followed later in the year with commencement of construction of another 40 singles on Kathryn Court which were completed and sold over the next six years (i.e., 1975 to 1981). Also in late 1975 Golden commenced construction of a 178-unit apartment building ("Regency Square") located elsewhere in the North Bay area with its first tenants taking occupancy during the fall of 1977.

From late 1976 to 1978 Golden proceeded with what was described as a second phase of home construction on the Sherryl Crescent and Belleview Crescent areas. Of the 25 housing units in issue, 19 were built during this phase; 18 out of the 19 were located on Sherryl and the other one was on Belleview Crescent. Two of the 19 were singles, with 17 being semis. The remaining six were semis built during 1983-84 on Southview Crescent and McGibbon Street. Each of the 25 housing units in issue had been rented for periods of time prior to sale in 1986/1987 and 23 had earlier been either sold with a buy-back warranty being exercised by the purchaser, rented with an option to purchase being granted or subject to an aborted sale. All had been advertised or offered for sale in some form (see infra).

Appellant-counsel's description of Mr. Orsi’s methodology respecting this phase was accurately summarized (pages 3 to 4 of his written argument) as follows:

Building permits were taken out in late 1976 and the beginning of 1977. Generally, construction of the housing units does not follow a set time table. The timing of the construction activities was very much a function of Mr. Orsi’s intuition. The company might, for example, dig ten or more foundation holes at a time, and continue digging even more foundation holes while the block layers were starting with the basements of the other foundation holes. The company tried to get the four walls, the roof and the shingles up within 90 to 120 days from the commencement of the construction activity. Often, partially finished homes were left for periods of two, three or four years before they were totally completed. The main factor influencing the completion of the construction with respect to particular houses was the existence of a buyer or a tenant. Tenants and purchasers were allowed to pick the carpets, pick the kitchen cabinets, and customize other such features of the housing unit. Often, large numbers of housing units would sit uncompleted. Mr. Orsi testified [. . .] that it was important for Golden Estates Limited to find quality tenants who could afford to pay the rent. In a sense, he suggested that the company would rather leave a unit empty than rent to an individual who could not afford to pay.

An equally strong motivating factor for this methodology of development was that the deferral of finishing costs enabled Mr. Orsi to continue building other houses of different styles in different locations in response to perceived market demands to attract other buyers or renters. He said he did not believe in selling housing units when the market was bad so rather than diminishing profitability derived from property sales their rental would pay the carrying costs, including taxes and mortgage payments. He confirmed that during 1980 to 1985 the selling market was bad, that during 1980 to 1983 one lender was pressing daily for sales to occur to pay down Golden's debt, and that in response to this pressure he had practised appeasement by listing with realtors and allowing sale signs to be placed on the housing units throughout the subdivision. Apparently a bank representative inspected the area daily.

Mr. Orsi testified that his original intention with respect to Belleview’s semi and single lots was to rent approximately 40 housing units although he confirmed he never put a firm number on it and that it was open-ended. His plan was to obtain this goal eventually, but in the meantime as he sold the housing units that may have been rented he built others in replacement to ensure the cash flow necessary to continue building.

Mrs. Koselek testified that Mr. Orsi told her in 1976 that he had wanted to keep approximately 30 to 40 of the housing units for rental purposes. She said that the intention respecting a semi for rent was that it would be adjacent to the other half which was, or would thereafter be, sold; the theory being an owner would look after his own thus shaming the tenant to do likewise. As it turned out however, (as confirmed by the testimony of Mr. Huggett, Mrs. Koselek and Mr. Orsi) if there was a buyer for any semi or single that was unoccupied it would be sold, and that no particular one had been specifically earmarked for rental. Mrs. Koselek said she tried to maintain the half-rental half-sale policy because it made sense to her. The evidence established at least eight instances of sales-related activity (whether by listing, advertisement or actual sale) respecting the half which, under the original plan, should have been a rental. Mr. Orsi’s explanation for this was in keeping with his overall philosophy (infra) that one cannot turn down business. Mrs. Koselek confirmed the plan fell by the wayside to some extent because "they had to make money". Mr. Huggett believed that if a buyer had come along to purchase all of the housing units they would have been sold. However he also believed there would have been a concurrent plan operating in Mr. Orsi's mind to build replacements for both rental and sale.

At page 10 of his written argument appellant's counsel conceded the facts (which I would add were founded on the evidence) that "the properties which were to be rented were not specifically earmarked from the start. The composition of the rental property stock was a fluid collection of properties which changed over time”.

As noted earlier, Mr. Bill Huggett was Golden's in-house accounting adviser. He obtained his certified general accountant's designation in 1978. He began his employment with Golden in August of 1983 and in 1984 he organized an amalgamation of a number of companies owned by the three Orsi children into Golden. Thereafter, he said, Golden's primary operations involved fibreboard manufacturing (its largest income source), rentals and the construction and sale of semis and singles. In the fall of 1988 he arranged a “butterfly” reorganization wherein Golden's assets were transferred on a tax deferred basis to three separate companies owned by each of the three Orsi children respectively. The construction of townhouse and apartment rental projects continued thereafter under different corporate names although the land and construction was continued by Golden as their nominee.

Mr. Huggett said that while all of Golden’s properties had been carried on their financial statements as inventory, this was an error which was corrected for the 1985 fiscal year. He acknowledged that all properties may have previously attracted trading or inventory characteristics because of the banker's pressures to sell for debt reduction which had perpetrated a need to represent them as liquid inventory. Golden's bank loans had been called in January of 1983 and its rental operations were in a loss position. New lenders were obtained, the bank was paid out during 1984 and Mr. Huggett said he was then in a position to remove the rentals from inventory and expense their interest and property tax costs.

Mr. Huggett opined that as the Belleview land was fully paid for and that as construction funding was via builders’ mortgages equal to or greater than those costs, the rental receipts would produce a pure return over costs. When pressed on cross-examination that his graphs portraying growth of rental assets were premised on gross rental receipts he defended the veracity of this approach by saying it was designed to portray rental activity, rather than the results of that activity, to show what the operations were and what functions were going on. He did concede however that if Golden had continued building more homes than could be sold gross revenues would rise in the same manner.

The following represents the (rounded out) financial results of the appellant's rental activities as reported in their financial statements for 1978 to 1988 inclusive:

There was evidence to indicate that not all expenses relating to Golden’s rental operations had been matched against revenue. Mrs. Koselek, who described herself as Mr. Orsi's “right-hand man”, actively supervised the rental operations and monitored the sales activity but was paid by another of Mr. Orsi’s companies. Also there was uncertainty as to quantum and appropriate allocation of insurance and advertising expenses. Accordingly the reported rental losses may well have been higher and the profits lower.

Mr. Huggett said he believed there were two principal reasons for the sales of the subject properties. Firstly, they had been rented and were aging and thus needed refurbishing. Secondly, the diversion of Golden’s equity to the McNamara multi-unit townhouse complex would pay for the shortfall between construction costs and the builder's mortgage and would result in a rental asset more economical to maintain and manage. Cross-examination however revealed that since completion of a unit occurred when a rental or sale was transacted many of the subject properties were relatively new when sold, and that in any event he could not say if Golden had any rental refurbishing policy.

It is appropriate to mention at this point that the evidence established construction of the remaining 22 units to the 44-unit McNamara townhouse development was completed in the fall of 1985, earlier draws on its construction financing had been received and rentals had begun in the fall of 1985. In other words the shortfall, said to be in the half million dollar range, was incurred before the decision to sell the subject properties was made in 1986 and therefore it cannot be said to have been unknown nor unanticipated. No evidence was led as to how Mr. Orsi intended to pay these shortfalls prior to commencement of construction in 1985.

This ties in with Mr. Orsi’s stated business philosophy and methodology which had created and continually exacerbated Golden’s financial frustrations and ongoing deficits. He said he was always in an “inventory overload”, that his approach was "never to clean the pot dry”, that his success was derived from keeping the building trade working and the cash flow going by “robbing Peter to pay Paul”, and that negative inferences would have been drawn if his construction and sales had stopped.

Four of the subject units located on Sherry! Crescent, lots 27E, 27W, 29N and 29S were sold in September of 1986 to acquire what Mr. Orsi thought to be a good site on which to build another rental project. These were touted to the vendor (Mr. Brown) as being Golden’s best long-term rentals which they convinced him to accept in exchange for his land. This was done and now, nine years later, rentals are in the process of being constructed thereon.

Mr. Orsi’s business approach was that when the selling market was not pleasant he would rent some and keep some, that rentals would pay carrying costs but that eventually all would be sold and reinvested in better and more manageable projects so as "not to let the pot run dry". It was admitted that the rentals charged did not cover or compensate for the value of Golden’s equity which was represented by the imputed value of the land. Mr. Orsi professed that a semi valued at $38,000 to $39,000 would then have been constructed for around $25,000 with mortgage financing of around $30,000 leaving an equity (of around $14,000) for future use purposes, concluding (transcript 582):

So, we can be comfortable to rent the house and with the intent that we do not all in one day the revenue, we want to spread it out. We will sell them some day if we need to, but the rent was a good thing to make the house work more and pays itself.

He frankly admitted he had operated on the premise that rental units would go up in value and that in the meantime Golden's equity would be useful as security pledges for future borrowings to keep the business going. He confirmed the early to mid-1980s had been very bad times, that he had a lot of houses on hand to be finished for sale or rent and that matters had improved somewhat after 1985.

According to the evidence the strongest demand of home buyers was for semis because they gave the best value for the dollar, Golden had an edge in sales through marketing their semis at less than the going rate, and they enjoyed a waiting list of renters. While sales were aggressively promoted, rentals were not as actively pursued. People that came to the subdivision in response to the marketing of the houses for sale could and would be advised by Golden to explore rental opportunities then available. One of Golden's staff would be on-site at all times for sales and rental purposes.

All 25 houses in issue were enrolled under Ontario's HUDAC Home Warranty Program which applied to newly constructed houses for sale only. Golden represented in its applications for registration in this program that the houses were for sale by speculation.

Mr. Orsi testified that the southerly Sherryl Crescent lots were chosen as the best location for rental houses at the outset because they backed onto an attractive green-belt area (a hydro right of way) which endowed them with the best potential for growth in future value. Of these, the lot numbers between 13 and 22 are in issue. Exhibit R-14 graphically illustrates Golden’s activities therewith, the contents of which were agreed to by appellant’s counsel. I have summarized the material in this exhibit as follows:

All of the above were semis and were vacant when the 1986/1987 agreements of purchase and sale were entered into. The numbers in brackets following the monthly rentals indicate the frequency of tenancies experienced during that particular time.

The north side of Sherryl Crescent was part of the second phase of Belleview’s development and initially designated as a desirable location for rental properties. I propose to continue my summary as it relates to the balance of the 25 lots in issue.

Exhibit R-14 did not incorporate particulars concerning sale ads placed by Angela Orsi and Mr. Orsi during 1978 in the North Bay Nugget newspaper. Through cross-examination of Mrs. Koselek it was established that these ads, portraying "over 50 homes to choose from starting at $38,000”, pertained to all of the housing units then under construction which included all the semis on Sherryl (therefore including 18 out of the 21 subject housing units, the other four being vacant lots until 1983). She did not know if any blanket sale listings were given to Kennedy Realty during 1978 even though they had placed ads in the newspaper during May to August of that year concerning the semis and singles located in Belleview Park. Mrs. Koselek agreed rental vacancy rates were very low in 1978 and 1979, that North Bay was experiencing shortages of rental properties and confirmed newspaper ads were done during 1978 respecting the marketing of the semis on Sherryl as rentals with option to purchase under the caption of "properties for sale or rent". She explained semis were always for sale as long as that did not deplete their rental inventory.

Further newspaper ads were placed by N.O.R.D. Realty in June of 1979 advertising sales in Belleview being available with no down payment, this being one of the various avenues of financing offered by Mr. Orsi to sell the semis. Mrs. Koselek confirmed her awareness of an arrangement made by Mr. Orsi in the fall of 1979 with Carlyle Realty to sell all of the houses in Belleview but opined it covered all houses “he would permit him to sell". Carlyle had proposed the buyback warranty which she knew Mr. Orsi had approved. This apparently was in response to a negative reputation arising out of faulty workmanship occasioned, as it turned out, by poor soil and backfill conditions.

Mrs. Koselek said she did not believe that during the ten-year period of 1978-1988 Golden had 30 to 40 rental units on hand at one particular time but rather was able to say they likely had around that number over those years. During redirect testimony however she was asked to confirm that at the time of the November 1988 “butterfly” reorganization there were 127 housing units on hand and that, with the subject 25 rentals being sold during 1986-1987 being added to 19 rental units then on hand, the total of 44 rentals out of 127 houses would accord with Mr. Orsi's original intentions of retaining that kind of numbers for rentals.

According to the testimony of Mr. Clarence Carlyle of Carlyle Realty, he was approached by Mr. Orsi in late 1979 or early 1980. A blanket listing for the sale of all the Belleview properties was negotiated and then given. He said many frustrations ensued. Frequently the house keys could not be located, some of the houses would be rented without prior notice, buyers were already wary, Mrs. Koselek was either obstructionist or seemed never to be around for liaison purposes with Mr. Orsi and that he then had reached a point where every offer he got was frustrated either because the property was said to be rented or “they just did not seem to want to sell”. He said during the early 1980s Golden’s listings were not given high priority by area realtors because the chances were they would not be able to sell, their efforts therefore producing little or no revenue. It was his feeling that Golden had not been serious about selling the properties because they either over-priced them or refused purchasers' conditions. Mr. Orsi in his evidence did indicate that if a realtor brought someone who was prepared to pay the listing price for a unit he would have sold provided it was not already rented.

Mr. Dennis Mong testified. He claimed he was North Bay’s top sales realtor for ten years in a row and that during 1982 to 1984 he was president of K & B Realty who were number one in sales. He said builders were very vulnerable during the early 1980s so they were normally targeted by realtors. Even with Golden being the largest builder, prior experience and knowledge about them had left him disinterested in their properties. He was of the view they were building too many of the same kind of housing units and were known to pull listings because of rentals. As far as he was concerned Golden’s listings were not secure to realtors even though another might have been given in substitution.

These events as described by Messrs. Carlyle and Mong are in keeping with the formerly described stalling techniques practiced by Mr. Orsi ostensibly in deference to the bank’s daily insistence of selling houses to pay down the debt. At this juncture it is appropriate to recall that sale prices were down and that this was a time of low rental vacancy rates with waiting lists for rentals.

Analysis and decision

Il has oft been said that profit motive alone is not sufficient to distinguish between business income and capital gains since both investors and traders are seeking profits; see for example the comments of Thorson, J. in M.N.R. v. Taylor, [1956] C.T.C. 189, 56 D.T.C. 1125 (Ex. Ct.) at pages 211-12 and 214 (D.T.C. 1137 and 1139). Moreover it is necessary to analyze and weigh the intentions of the appellant as stated against its actual conduct with respect to the property in question.

The evidence is uncontradicted that Golden wished to retain a certain number of housing units as rental, that such numbers were on hand during 1986 when the decision to sell the subject 25 properties was made, and that Mr. Orsi had as consideration the development of a base of Golden’s rental properties for his children. The issue here focuses upon the intention and purpose for retaining each of the subject properties.

Mr. Orsi was a very astute and pragmatic businessman. He was fully aware that Golden did not have that kind of capital on hand or available to it which would have enabled it to build and retain these properties exclusively as capital assets. He was at all times prepared to appropriately respond and react to meet the exigencies of the times; thus, as he put it, each of the properties here could and perhaps would have been sold over time if the price was right but others would nave been built in their place so as "not to let the pot run dry".

By Mr. Orsi’s own admission, no houses in Belleview were earmarked specifically for rental rather than sale. Indeed all were registered as houses for sale under the HUDAC program and all had been recorded as inventory until 1985. All but one had some history of sales related activity whether by way of sale ads, listings (for whatever purpose), sale and buy-back, or rent with a formal or informal purchase option.

The above are indicators that the properties in issue had not been segregated from Golden’s business of building and selling houses but rather, for pragmatic reasons, were an integral part of it. This may indeed be contrasted with its treatment of the multi-unit projects constructed strictly for rental purposes, such projects not being built to an intermediate stage of completion so as to be able to react to a buyer or a renter, nor had they ever been directly or indirectly advertised for sale or sold.

While the appellant’s reliance on gross rental receipts does show that its rental stock had indeed increased, this of itself does not negate the situation of a poor market precluding profitable sales thus leading to rentals of this stock as an interim measure. Rentals, per se, do not act as an exclusive indicator that the subject properties were capital assets, but they are an important consideration. As indicated by respondent's counsel, it may not have been coincidental that Golden’s rental activities in Belleview increased substantially between 1981 and 1985 which is the period during which Mr. Orsi had said sale prices were low and that “all the fat had gone” out of the market. Thereafter, with an admitted improvement in selling prices, the subject properties were sold for profit to generate funds to acquire land for future development and to finance the McNamara townhouse shortfall.

In my view, when looked at in its entirety, the rental of the subject properties formed an integral part of Golden's profit making scheme to be gained from the construction of houses. Income was anticipated from three activities: selling, renting and capital appreciation. The subject properties were built as inventory and sold as inventory, their interim or transient use as rentals did not alter or convert their character to capital. They were and remained an essential cog in Golden’s profit making wheel and bore the indicia of trade. A commercial animus permeated these properties which was occasioned by Golden's need for working capital which was materially derived from sales. Expressed another way, Golden had not yet reached the stage where it was financially able to enjoy being possessed of these 25 properties as investments rather than as inventory.

Counsel for the appellant submitted one of the best ways of proving original intention was to demonstrate that it had actually come to fruition and that the dominance of Golden and its successor corporations (post "butterfly") as landlords in the North Bay market ought to be considered as a clear indicator that it possessed an original intent to build up its base of rental property. While this logic houses certain attractions, it remains superficial and begs the question as to how it reached this state of success.

The manner in which these properties were held was consistent with Golden's practice and manner of doing business. In my opinion the evidence falls short of supporting the appellant's proposition that provision of wealth and income for Mr. Orsi's children was one of the principal motivational factors respecting the retention of these particular properties. Rather this underlying desire remained subservient and ancillary to Golden’s financial growth which From all appearances was still evolving during 1986/1987.

Alternatively if my conclusions had been otherwise, I would have held that the evidence supports the application of the doctrine of secondary intent; viz, Racine, Demers & Nolin v. M.N.R., [1965] C.T.C. 150, 65 D.T.C. 5098 (Ex. Ct.). The appellant, through Mr. Orsi, at all material times had the dual intention to either sell or rent the subject properties as the circumstances may have proscribed.

The appeals are dismissed with party-to-party costs to the respondent.

Appeal dismissed.