Trent Valley Sand and Stone Limited v. Her Majesty the Queen, [1993] 1 CTC 2717, 98 DTC 2255

Sarchuk, T.C.C.J.:—This is an appeal by Trent Valley Sand and Stone Ltd. (Trent) from assessments of tax with respect to its 1985, 1986 and 1987 taxation years.

In computing its income for those years Trent sought to deduct losses incurred in the operation of its racing stable in the amounts of $349,758, $225,312 and $52,921 respectively. By reassessment the Minister of National Revenue (the Minister) restricted the claimed losses to $5,000 for each of the taxation years. The reassessment was made on the basis that Trent's chief source of income was neither farming nor a combination of farming and some other source of income and that accordingly the losses were properly restricted pursuant to subsection 31(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

Trent maintains that the losses suffered by it in the operation of its racing stable are deductible in full against its other sources of income and that section 31 of the Act is not applicable. In support of its position evidence was adduced from Bruce H. Lloyd (Lloyd), the president and chief executive officer of Trent and from Thomas S. Worden, a chartered accountant and the person responsible for the preparation of Trent's financial statements since 1981.

Mr. Lloyd's father incorporated Trent in 1953. Lloyd joined the company that same year. In 1967 he acquired his father’s interest, which at the time gave him ownership of 77'/2 per cent of the issued shares. Until 1979 Trent was involved solely in the aggregate business, being the extracting, processing and selling sand and stone. This business was a steady income producer and by 1979 Trent had reasonable cash reserves available to be put to other uses. Although Lloyd remained in control qualified staff was handling most of the day-to-day operations of Trent. Benefiting from more free time, Lloyd began to look for new opportunities. As a young man he had been active in his father's involvement with hunters and jumpers, and he continued to have an interest in horses. He considered a Standardbred racing operation and investigated the practicability of such a move by consulting breeders, trainers and other individuals involved in that business. He began to study Standardbred bloodlines, made inquiries regarding the cost of trainers and of purchasing and keeping horses. In due course he became convinced that money could be made. Having done so he consulted his accountant and acting on his advice chose to pursue the venture through the appellant corporation.

In 1979 Trent hired a trainer and with his assistance Lloyd began to assemble a racing stable. Trent made its first acquisitions that fall, a 50 per cent interest in one Standardbred horse and full ownership of a second at a total cost of $98,000. In 1980 and 1981 further purchases were made to a total of $49,000 and $151,000 respectively. [1]

While Trent's intention was to acquire horses for the purposes of racing it never intended to build or buy any facilities. Rather its stable was to be developed by purchases at yearling sales supplemented by its own breeding program. The horses were placed in the hands of the trainer who was responsible for all arrangements including boarding, training, breeding, equipment and transportation to races. In this way, with careful attention to breeding lines and sound selection of yearlings at the sales, Trent hoped to produce a stable of good stake horses.

For all practical purposes, Lloyd was the sole Trent employee involved in the racing operation and made all of the decisions. When embarking on this venture he expected losses in the first two years to be followed by increasingly significant profits. That had not occurred by the end of 1982. Lloyd ascribed the losses to an absence of racing luck in 1981 and some racing luck, but not enough, in 1982. In addition there were unforeseen and unpredictable events such as illness and injuries to the horses. According to Lloyd the most reasonable approach to reducing expenses at that time would have been the speedy identification and disposition of horses which were not producing. He conceded that he should have rid Trent of some of the unlucky horses sooner but said the decision to keep them was a business decision and not a beginner's mistake. Although no changes in the manner in which the operation was conducted appear to have been seriously considered at this time Lloyd continued to believe that Trent could make its investment worthwhile.

From 1982 to 1987 Lloyd attended all major horse sales, became more involved in the training program and continued to acquire knowledge and skill in these areas. Under his management Trent expanded the stable, building up what Lloyd hoped was an inventory of quality horses. He expected this would lead to significant profits, both from purses won and from the sale of horses. The accountant, Worden, testified that from 1985 to 1987 a total of $1,085 174 of Capital was invested in Trent of which $574,784 was committed to the aggregate business while $510,390 was committed to the racing stable.

During this same period Trent's aggregate business continued to be profitable. In the early 1980s, to broaden its business base, it had developed a custom crushing capability designed to service the mining industry. In 1986 it signed a crushing contract with Noranda Mines for the Hemlo site which was in Lloyd's words “fair sized” and “in a financial sense very rewarding”. Other contracts followed and the custom crushing operation continued to be profitable. Notwithstanding Lloyd's assertions that Trent would not have become involved in a racing stable absent a realistic expectation of profit, the fact remains that during the 12 years that Trent operated the stable, only once was a profit shown and the most recent loss, in 1991 amounted to $226,535 (Exhibit A-15).

Appellant's position

Counsel for the appellant contends that the evidence adduced satisfies the criteria established for the purposes of subsection 31(1) of the Act in Moldowan v. The Queen, [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213. In particular he argues that the amount of capital committed to the racing venture by Trent, the time spent by its directing mind Lloyd and its potential for profit demonstrate that farming was Trent's chief source of income in the taxation years in issue.

Respondent's position

Counsel for the respondent submits that the criteria established in Moldowan, supra, must be considered with reference to the actions of the corporation as a whole and should not be restricted to or confused with the actions of its sole shareholder. He argues with respect to time spent, that Lloyd's devotion to the racing stable cannot be confused with the focus and direction of the corporation. It continued with its aggregate business, continued to invest significant amounts in the purchase of new assets and continued to generate profits which enabled it to spend substantial amounts of money on the racing stable. Furthermore, the absence of profitability in the horse racing venture demonstrates that it was not and could not be significantly profitable relative to the aggregate business.

Conclusion

If Trent is to be successful in its appeal it must establish on a balance of probabilities that its chief source of income in the taxation years in issue was a combination of farming and another source of income. The authoritative decision on this subject is Moldowan, supra. Dickson, J., as he then was, stated at page 486 (C.T.C. 314, D.T.C. 5215-16):

Whether a source of income is a taxpayer's “ chief source” of income is both a relative and objective test. It is decidedly not a pure quantum measurement. A man who has farmed all of his life does not cease to have his chief source of income from farming because he unexpectedly wins a lottery. The distinguishing features of “chief source" are the taxpayer's reasonable expectation of income from his various revenue sources and his ordinary mode and habit of work. These may be tested by considering, inter alia, in relation to a source of income, the time spent, the capital committed, the profitability both actual and potential. A change in the taxpayer's mode and habit of work or reasonable expectations may signify a change in the chief source, but that is a question of fact in the circumstances.

[Emphasis added.]

In The Queen v. Poirier, [1992] 2 C.T.C. 9, 92 D.T.C. 6335, at page 10 (D.T.C. 6336) MacGuigan, J.A. said with respect to the meaning of the word "combination" in subsection 31(1) of the Act:

The learned judge here seems to suggest that farming income can be combined with, in the sense of supplemented by, another source of income in order to constitute a chief source of income. It is clear from Moldowan v. The Queen, [1977] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213 at page 487 (C.T.C. 314, D.T.C. 5216, that the word "combination" in subsection 31(1) is not to be read in that sense. It is also now clear that what is required for a determination that farming is a chief source of income is a favourable comparison of farming with the other source of income as to such matters as the time spent, the capital committed, and the profitability, both actual and potential: The Queen v. Connell, [1988] 1 C.T.C. 247, 88 D.T.C. 6166 (F.C.T.D.) (Strayer, J.), approved on that point by this Court in [1992] 1 C.T.C. 182, 92 D.T.C. 6134.

[Emphasis added.]

and:

It must be remembered that it is the cumulative impact of the various factors for determination that governs, not any one factor taken disjunctively: Morrissey v. Canada, [1989] 1 C.T.C. 235, 89 D.T.C. 5080 (F.C.A.) and Connell, supra (F.C.A.).

With these guidelines in mind I turn to the evidence and submissions.

Time spent by taxpayer

Counsel for the appellant submits that Lloyd, the directing mind of Trent, devoted at least 50 per cent of his time to the racing stable and that Trent through its principal shareholder demonstrated an intention to change direction and to emphasize that aspect of the business in the future. He argues that the number of Trent employees involved in that activity as compared to the aggregate business was not a relevant factor in analyzing the criteria of time spent.

There is no doubt that Trent's principal shareholder devoted most of his time to the horse racing operation. However for a number of reasons his involvement falls short of establishing that Trent's "time spent" or its "occupational direction" had changed. First, virtually all of its staff remained involved in the aggregate business. During the years that Trent operated its racing stable the number of its full-time employees varied from 24 to 40 of whom only two, both clerical staff, were involved in racing stable related work and then only marginally. [2]

Furthermore at about the same time that Trent became involved in horse racing it developed an alternative aspect to its aggregate business: custom crushing, which provided a substantial portion of Trent's profits in the taxation years in issue, this I might add, in sharp contrast to the racing operation. Revenues from this expanded aspect of the aggregate business amounted to $2.9 million in its 1987 taxation year and $1.5 million in its 1988 taxation year.

It is difficult to find that a change in occupational direction occurred when on the facts it is evident that since its inception to the present time the racing operation has never turned a profit and has been totally subsidized by the aggregate business.

Capital committed

It is contended on behalf of the appellant that between 1985 and 1987 important changes occurred in the structure and direction of Trent. In those years almost 50 per cent of new available capital was committed to the racing stable. This, it is argued, clearly establishes that the focus of Trent was and would continue to be the racing stable. Counsel also urges the Court not to look at the “historically spent capital” since it was not relevant for consideration or comparison with the capital invested in the racing stable as this factor applied to the taxation years in issue.

It is a fact that Trent invested a substantial amount of money in the racing stable but that must be weighed in light of Trent's investment of significant amounts in the purchase of new portable assets to pursue very lucrative custom work. It is also arguable, if one views the taxation years in isolation, to say that in terms of capital committed the racing stable comes close to achieving a favourable comparison to the aggregate business. However in my view it is inappropriate to focus on these years in that fashion and to ignore the historically spent capital. In this context the appellant's argument is in general without much merit. Trent had invested approximately $3,250,000 in the aggregate business by the end of its 1979 taxation year. By 1991 that investment had increased to $5,400,000. During that same period the capital invested in racing was $643,099. A sizeable amount but hardly a favourable comparison to that expended on the aggregate business.

Profitability, both actual and potential

Counsel for the appellant contends that the evidence of Lloyd more than adequately supports the existence of a reasonable expectation of profit to be derived from the racing stable. He refers to the decreased losses reported for the 1985, 1986 and 1987 taxation years [3] as establishing a movement towards profitability and suggests that the financial statements for those years could be read to show that concurrently the profitability of the aggregate business was declining. These factors, he argues, establish that the racing stable was Trent's chief source of income in the years in issue.

Counsel for the appellant also contends that the actual and potential profitability of the horse venture should be evaluated based on realistic figures. Had it not been for the purchase of new horses (contributing to the growth of the business) in the 1984, 1985 and 1986 taxation years, the figures would have shown a substantial profit. By his calculation Trent showed an after tax profit in 1989 of some $5,842 resulting from the racing venture, after deducting the purchase of new horses for more than $254,000. This demonstrates the existence of profitability since the real profit would have been $364,000 had the business not had to purchase the new horses. This theoretical profitability in the taxation years in issue demonstrates that Trent was looking for its livelihood to farming in combination with another source of income.

The simple fact of the matter is that throughout all of the years but one the racing stable consistently generated large losses. Mr. Lloyd conceded that in 1985 and 1986 Trent was not "making the money" it expected from the racing stable. Nonetheless Lloyd believed that with the capital invested the return would ultimately be worthwhile. He premised his optimism on the fact that in those years and in 1987 Trent had acquired several horses at yearling sales, three in particular for whom "they had high hopes" and a fourth which was described "as a real steal". Lloyd stated that Trent was looking for" big things as far as purses were concerned" from these acquisitions. However a perusal of the profit and loss statements for those years and subsequent years suggests that this optimism was misplaced. As to the" real steal" the testimony was that "she was an absolute flop”.

There is no evidence of any reasonable business plan being formulated for the racing operation either at its inception or at any subsequent time. Lloyd stated that "we used our own studies, our own analyses” which were based on his discussions with others in the Standardbred business. While he asserted that he knew what training costs, veterinary costs and other related expenses were involved and on that basis knew what was needed to break even, that never happened. I note as well that with respect to the expenses incurred in operating the racing stable the cost of the Trent employees involved was not attributed to that venture nor was the substantial amount of time expended by Lloyd.

The comments of Strayer, J. in Mohl v. M.N.R., [1989] 1 C.T.C. 425, 89 D.T.C. 5236 (F.C.T.D.), at page 428 (D.T.C. 5238-39) are relevant as to what this taxpayer must establish.

It now appears clear from the Supreme Court decision in Moldowan, supra, as recently interpreted by the Federal Court of Appeal in Canada v. Morrissey, [1989] 1 C.T.C. 235, 89 D.T.C. 5080 that, for a person to claim that farming is a chief source of income, he must show not only a substantial commitment to it in terms of the time he spends and the capital invested, but also must demonstrate that there is a reasonable expectation of it being significantly profitable. I use the term "significantly profitable" because it appears from the Morrissey decision that the quantum of expected profit cannot be ignored and I take this to mean that one must have regard to the relative amounts expected to be earned from farming and from other sources. Unless the amount reasonably expected to be earned from farming is substantial in relation to other sources of income then farming will at best be regarded as a "sideline business" to which the restriction on losses will apply in accordance with subsection 31(1).

[Emphasis added.]

On balance the appellant Trent has not demonstrated that the racing venture has the potential to be significantly profitable.

Trent has not established that farming was its chief source of income whether alone or in combination with some other source, with the result that losses arising from its farming activity were properly restricted by the Minister of National Revenue for its 1985, 1986 and 1987 taxation years in accordance with section 31 of the Act.

The appeals are dismissed.

Appeals dismissed.