John Skarja v. Minister of National Revenue, [1985] 2 CTC 2104, 85 DTC 477

Taylor, TCJ:—This is an appeal heard in Toronto, Ontario, on May 13, 1985 against income tax assessments for the years 1979 and 1980 and 1981 in which the Minister of National Revenue disallowed as a deduction from other taxable income, the loss claimed by the taxpayer from a rental operation. The recital of the critical facts by the Minister in the reply to notice of appeal remained at the close of the hearing virtually unchallenged and can serve to put the matter into perspective:

— in April, 1976, the Appellant purchased a property located at Casablanca Boulevard consisting of buildings and 6.82 acres of land (hereinafter "the property”);

— the Appellant purchased the property subject to a mortgage for 10 years at an effective rate of 10 percent, resulting in mortgage interest liability of $19,025.00 in the 1979 taxation year and $19,000.00 in the 1980 and 1981 taxation years respectively;

— on September 15, 1976, the Appellant leased the property to Skarja Greenhouses, a business operated by his wife as a sole proprietorship, for 10 years effective April 20, 1976;

— pursuant to the terms of the lease, the property was rented for $14,400.00 per annum;

In striking the assessments the Minister relied on the following:

— the Appellant and his spouse were not dealing at arm’s length;

— the property was not leased for profit or with a reasonable expectation of profit;

— the expenses incurred by the Appellant with respect to the property were not outlays or expenses incurred to earn income from a business or property.

The respondent relied inter alia, upon paragraphs 18(1)(a), 18(1 )(h) and 20(1 )(c) of the Income Tax Act, RSC 1952 c 148 as amended.

I would note at the outset, that the Minister’s reference to paragraph 20(1 )(c) of the Act was not pursued by the respondent at the hearing, and to that degree the decision will not be based thereon. The conduct of the hearing by both parties seemed directly related to the application of paragraphs 18(1)(a) and 18(1 )(h) of the Act.

The case lends itself in a peculiar way to an examination of the point at issue, because there are just two critical amounts involved — the payment of interest by Mr Skarja, and the receipt of rent from his wife. The payment of the interest was the taxpayer’s obligation arising out of the contract of purchase and sale of the greenhouse property for a total of $240,000, of which some $190,000 remained as a mortgage payable to the vendor, a Mr Zimmerman, that mortgage being an annual interest rate of 10 per cent. The term of the mortgage was five years with a renewal clause for a further five years. It also provided for repayment in full at any time without penalty. On the other side of this issue the amount of $14,400 interest received by the appellant arose out of an agreement, separate from the purchase and sale agreement noted above, between the appellant and Claudia Skarja, his wife, within which Mrs Skarja was to operate the greenhouse business — using all the assets acquired by Mr Skarja at the total cost of $240,000. The lease with Mrs Skarja was a "net-net” lease, leaving this appellant, in effect, with nothing to pay out of his receipt of $14,400 per year. The issue in this appeal, therefore, arises out of the situation that, even under those very favourable "net-net” lease conditions, the calculated, committed, and immutable revenue could not meet the calculated, committed and immutable expense.

The taxpayer in testimony asserted that he had expected to be able (out of his substantial separate salary earnings or other investments) to pay down the mortgage, and thereby reduce his obligation (presumably to something less than $14,400 per year) and accordingly produce a profit in the ensuing years. His reason for not doing so was simply that interest rates of investment income rose sharply in the years subsequent to 1976, and he found that as a prudent businessman, it was much more to his advantage to leave intact the 10 per cent Zimmerman mortgage obligation (supra) and use his spare funds at interest rates considerably in excess of that (he indicated 13 per cent to 19 per cent in certain instances).

In argument counsel for the appellant dealt with two issues — first, that by not following through on his original intention (to pay down the Zimmerman mortgage) the appellant had not changed direction, and thereby invalidated his original “profit” purpose, but rather had only acted in a sane and sensible way. In addition there was no compunction under the Income Tax Act for him to act in any other manner when the opportunity for a better investment on reserve funds arose. Second, that in any event, the only purpose for which Mr Skarja could possibly have entered into this agreement with his wife was to “gain or produce income” and his conduct so demonstrated, in the words used in the notice of appeal: “At all times, Mr Skarja expected a profit to ensue from his ownership of the property

I would refer to two quotations — one from Warden v MNR, [1981] CTC 2379; 81 DTC 322, found at 2389 (DTC 329):

. . . When a taxpayer claims expenses which are in excess of income, then, he must assume the difficult task of showing that these “excess” expenses were rational and reasonable — those which a normally wise and prudent man intending to improve, not reduce his financial position, would incur under the circumstances.

and the other from Deputy Minister of Revenue of Quebec v J Lipson, [1979] CTC 247 at 250:

It is perfectly clear from these provisions that, in order for an expense to be admissible as a deduction from a taxpayer's income, it must have been incurred in order to make a profit. It is not enough that the expense was incurred in order to obtain gross income, as counsel argued at the hearing. By virtue of section 5, to gain income means to yield a profit. In the case at bar, there is no basis for finding that in renewing the lease for the last two years the members of the syndicate expected to make a profit. The only evidence submitted was as to the expectations they had on signing the lease, but these expectations were not realized and the factors which caused the losses in the first three years were still present when the lease was renewed. No one therefore could imagine that a loss would not be incurred. It is accordingly clear that the sole reason for the renewal was that stated by the respondent: to create a deductible loss by means of a disadvantageous contract, instead of advancing capital. The actual purpose of the operation was not to make a profit but to put money into the company by incurring a loss to its benefit.

The “alternate and prudent investment choices” argument made by the appellant’s counsel is patently unsupportable. The only possible way in which the appellant could hope to produce even a cash flow profit during the years in question was to pay down the Zimmerman mortgage, (leaving aside for the moment that this “profit” would have likely ignored any imputed interest on his own increased investment). I am only mildly impressed with his alleged intention to do so, but his conduct in not doing so negates even the assertion he makes that this was his objective and plan. Even if I accepted that his original purpose was as he contends it (to further his own funds and produce a profit on the lease with Mrs Skarja) he changed that critical aspect of the plan, and thereby the non-production of profit was not the result of external frustration or activity, but directly from his own course of conduct. He cannot now seek further relief and benefit from the income tax system (see Kruger v MNR, [1977] CTC 2311; 77 DTC 208).

However, the major flaw in the appeal is specifically to be found in the second point made by the appellant — and dealt with in the quotation from Lipson (supra) — the entire agreement was structured — and I am satisfied consciously so — by the taxpayer to produce the results it did — an alleged rental loss deductible by him from other taxable income. I am not aware of jurisprudence which would support the taxpayer in such an endeavour, and permit the distortion which could result.

The appeal is dismissed.

Appeal dismissed.