Theodore P. Michael v. Minister of National Revenue, [1991] 2 CTC 2131, 91 DTC 1076

Mogan, T.C.J.:—In October 1983, the appellant purchased a house at 24 Nevada Avenue, Willowdale, Ontario, immediately north of Toronto. In order to finance that purchase, the appellant granted a second mortgage in the amount of $45,000 on the house at 374 Lawrence Avenue West, Toronto where he had lived since 1968. On October 31, 1983, the appellant and his family moved from the Lawrence Avenue house to the Nevada Avenue house. From and after October 31, 1983, the appellant retained the Lawrence Avenue house as a rental property. In computing his rental income from the Lawrence Avenue house, the appellant deducted the interest paid with respect to the $45,000 second mortgage. The respondent disallowed the deduction of that interest. The first issue in this appeal for the 1985 taxation year is whether the interest paid or payable with respect to the $45,000 second mortgage is deductible in computing rental income from the Lawrence Avenue property. There is a second and distinctly different issue which is described in the latter part of these reasons for judgment.

The appellant makes the following arguments concerning the first issue. A change in use of the Lawrence Avenue property occurred on October 31, 1983 when, for the appellant, it ceased to be a personal residence and became a rental property. On November 1, 1983, there was a deemed disposition and reacquisition of the Lawrence Avenue property. Upon such reacquisition, the appellant assumed the first and second mortgages and their status changed to business mortgages with the interest becoming deductible for income tax purposes. Any third party purchasing the Lawrence Avenue property to earn rental income would assume both mortgages and would be entitled to deduct the interest on both mortgages in computing rental income. The appellant was able to retain the Lawrence Avenue property as a rental property only by arranging the second mortgage of $45,000. Those are the appellant's arguments.

In my view, there are two fundamental errors in the appellant's reasoning. Firstly, he has ignored the condition in paragraph 20(1)(c) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") that interest on borrowed money may be deducted only when the money is borrowed “for the purpose of earning income from a business or property". In this case, the $45,000 was not borrowed for the purpose of earning income from property but for the purpose of purchasing a personal residence on Nevada Avenue. I do not accept the appellant's statement that he was able to retain the Lawrence Avenue house as a rental property only by granting the second mortgage. It would be more accurate to say that the appellant avoided a sale of the Lawrence Avenue property to obtain cash for the Nevada Avenue purchase by persuading the vendor of the Nevada Avenue property to accept the second mortgage as part consideration for his sale price.

The second error in the appellant's reasoning is his assumption that unlimited borrowing with respect to a particular rental property will always result in tax deductible interest. An expense is deductible only to the extent that it is reasonable in the circumstances. See section 67 of the Income Tax Act. If a particular rental property is encumbered with so much debt (i.e., mortgages) that the interest payable on the mortgages exceeds the gross rentals, the owner should not expect to deduct all such interest so as to produce a rental loss to be applied against income from other sources.

To conclude this first issue, the $45,000 represented by the second mortgage on the Lawrence Avenue property was not borrowed for the purpose of earning income from business or property but for the purpose of purchasing the appellant's personal residence at 24 Nevada Avenue. The interest on the second mortgage is therefore not deductible in computing the appellant's income for 1985. I am reinforced in this conclusion by tne decisions in Holot- nak v. The Queen, [1987] 2 C.T.C. 217; 87 D.T.C. 5443 (F.C.T.D.) and [1990] 1 C.T.C. 13; 89 D.T.C. 5527 (F.C.A.) and Holmann v. M.N.R., [1979] C.T.C. 2653; 79 D.T.C. 594.

The second issue concerns the deductibility of certain amounts paid by the appellant to a corporation following the assignment of a lease. In 1975, the appellant and his wife acquired York Mushroom Company Ltd. ("York") which operated a mushroom farm on 24 acres of land which it owned at 10101 Weston Road in Woodbridge, Ontario. After trying to operate the farm from 1975 to 1977, the appellant and his wife decided to retain the corporation (York) but to lease the land to other persons who had more experience in mushroom farming. In August 1978, York leased the 24 acres to an arm's length tenant for an annual rent of $30,000 per year payable at the rate of $2,500 per month.

On January 1, 1979, York assigned the lease to the appellant pursuant to an agreement in writing. Because this agreement is short and is the heart of the second issue, I shall set it out in full.

For valuable consideration received, York Mushroom Company Ltd., hereby sells, assigns, and sets over unto T.P. Michael, all its right, title and interest in the attached leases.

Further, T.P. Michael shall have the first right of refusal to purchase, subject to the existing leases, the subject property.

Provided that in return, T.P. Michael, covenants to pay York Mushroom Company Ltd., an annual rent of $30,000,000, at the rate of $2,500 monthly, and in addition to pay for reasonable repairs and administrative expenses, for the term of the lease agreement which expires, December 31, 1983. Also, T.P. Michael shall have a further option of five years to renew, on same terms.

Dated at Toronto, this 1st day of January 1979.

York Mushroom Company Ltd.

Per: T.P. Michael

T.P. Michael

The above agreement did not identify or define “the subject property" but the agreement was in turn assigned by the parties on July 31, 1980 to York Mushroom Company (1980) Ltd. (“the 1980 Co.") in accordance with the following document.

For valuable consideration the attached lease agreement, between York Mushroom Company Ltd. and T.P. Michael, dated, January 1, 1979, is hereby assigned to York Mushroom Company (1980) Ltd. and agreed to, by theundersigned.

Dated at Toronto, this 31st day of July, 1980.

York Mushroom Company Ltd.

Per: T.P. Michael

York Mushroom Company (1980) Ltd.

Per: T.P. Michael

T.P. Michael

The relationship between York and the 1980 Co. was not adequately explained in evidence and it is not clear from the document dated July 31, 1980 who was the assignor. It appears, however, that York was the assignor because the appellant's obligation was later reduced to $2,000 per month and, in the years 1985, 1986 and 1987, the appellant paid $2,000 per month to the 1980 Co. I can only assume that the land at 10101 Weston Road was transferred from York to the 1980 Co. because ownership of that land was the basis of the appellant's monthly payments of $2,000. In any event, the appellant and/or his wife owned all the shares in both corporations.

From the first assignment of the lease on January 1, 1979, in each year the rents which the appellant received from the arm's length tenants of 10101 Weston Road were less than the $24,000 which the appellant paid under the terms of the lease assignment agreement. As a consequence of being the lessor's assignee of the lease for the Weston Road property, the appellant reported the following losses as sublessor:

In this appeal for the 1985 taxation year, the respondent disallowed the deduction of the amount of $12,316 as a loss with respect to a rental property and the respondent argues (i) that the appellant did not have a reasonable expectation of profit from being sublessor of the Weston Road property; and

(ii) that expenses incurred with respect to the Weston Road property (in excess of revenue) were not incurred for the purpose of gaining or producing income within the meaning of paragraph 18(1)(a) of the Income Tax Act.

The original lease assignment of January 1, 1979 does not support the appellant's position because he undertook to pay an annual rent of $30,000 to York plus reasonable repairs and administrative expenses at a time when the arm's length lessee was obligated to pay $2,500 per month or $30,000 per year. It was always going to be a losing proposition to the appellant as sublessor unless the gross annual rent from the arm's length tenant exceeded $30,000 plus the cost of repairs and administrative expenses. According to the appellant's own testimony, each successive arm's length tenant on the Weston Road property after 1977 failed to honour its lease and make a profit from operating the mushroom farm. Therefore, there was no reason to believe that any arm's length tenant could afford to pay rent at the rate of even $2,000 per month and operate the mushroom farm at a profit on the Weston Road property.

I find that the appellant did not have a reasonable expectation of profit when he accepted the assignment of the lease from the lessor and undertook to pay the lessor $30,000 per year plus other expenses. Even when his obligation was later reduced to $24,000 per year, he still had no reasonable expectation of profit. There is further testimony of the appellant which defeats his appeal on the second issue. He stated that he took the assignment of the lease and guaranteed the annual payments (originally $30,000 later reduced to $24,000) because his corporation needed the cash flow. In other words, he absorbed the risk of default by the arm's length tenant in order to guarantee a healthy cash flow to his corporation. The appellant's implicit acknowledgement that such a risk was realistic has made it more difficult for him to prove that he, as sublessor, had a reasonable expectation of profit.

And lastly, the appellant stated that, as consideration for such risk, he received a “first right of refusal to purchase" the Weston Road property. In my opinion, this was no consideration at all because the appellant already had that right as the controlling shareholder of York and the 1980 Company. No corporate balance sheets were entered in evidence and so I cannot determine whether York or the 1980 Co. was undercapitalized. It may be that the appellant entered into the lease assignment agreement as an attempt to provide additional capital to his corporation on a tax deductible basis. The onus was on the appellant to prove that he had a reasonable expectation of profit by accepting the lease assignment as sublessor; and he has failed to discharge that onus. I am supported in my conclusion by the recent decision of this Court in Huot v. M.N.R., [1990] 2 C.T.C. 2364; 90 D.T.C. 1818.

The appeal is dismissed with respect to both the first issue and the second issue.

Appeal dismissed.