Sznitko v. R., [1998] 1 CTC 2484

Rowe T.C.J. (orally):

The appellant appeals from an assessment of income tax for the 1991, 1992, and 1993 taxation years. In computing income for those years, the appellant claimed rental losses of $11,737.47, $11,802.03, and $8,486.85 respectively. In reassessing the appellant for the taxation years under appeal, the Minister —

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MR. BORNSTEIN: Your Honour, I apologize for interrupting you. It occurred to me that in the calculations, there was - nothing was taken out in 1993 in respect of the last two months for the costs — for the expenses.

MR. HAYASHI: Yeah, that was the other thing I was wondering about -

MR. BORNSTEIN: I’d forgotten completely, and I apologize for interrupting.

HIS HONOUR: Okay. Sorry?

MR. HAYASHI: How do you want to deal with the expenses?

HIS HONOUR: Well, I will tell you what. You can make a — two months would be a 12 -- two months out of 12 would be —

THE REGISTRAR: Divide it by 12.

HIS HONOUR: Divide it by 12 and multiply it by 10.

Okay. Can you do that quickly.

THE REGISTRAR: That’s the $6,424.23?

HIS HONOUR: Right. So, in other words, if you have - you already took - yes, it would be $6,424.23; right?

MR. HAYASHI: It’s $5,353.52.

HIS HONOUR: $5,353.50?

MR. HAYASHI: Yeah. 52. That’s /i of the —

HIS HONOUR: $5,353.52?

MR. HAYASHI: Right.

HIS HONOUR: Okay. Have you got that, Mr. Registrar?

MR. BORNSTEIN: Thank you.

HIS HONOUR: Okay. Thank you for pointing that out.

Okay. Where were we? What was my last golden pearl?

—Reporter reads back.

HIS HONOUR: Okay. Good enough.

The Minister disallowed the deduction of rental losses, doing so on the basis that for those particular years, the appellant did not have a reasonable expectation of profit from renting the particular property in question.

Prior to hearing all of the evidence, one of the exhibits that was filed was a recalculation by Mr. Hayashi, the chartered accountant for the appellant, of a revised schedule of rental losses, which was done on the basis that, initially, there had been an amalgam of capital and other nondeductible expenses included in the amount submitted by the appellant for rental losses.

Accordingly, it is not an instance of applying thereafter section 67 of the Income Tax Act; rather, it is a realization in the middle of the evidence, for presentation purposes, that the court had to be made aware of the fact that the claim of the appellant was being revised, and that the losses were substantially less than originally submitted to the Minister in the tax returns for the 1991, 1992, and 1993 taxation years.

In August of 1988, the appellant purchased a property in Mississauga, Ontario. The evidence was that, initially, the property was looked at with the advice and assistance of Mr. Stitski, a real estate broker, from Etobicoke, who had in the past sold a property to the appellant’s mother, which she later used as a rental property and, fortunately, enjoyed thereafter a doubling and then a tripling of the original value in 1980.

Various properties were looked at, and some already had three separate rental units but were too expensive. Ultimately, then, Mr. Stitski showed the appellant the property, which is the subject property, located at 1220 Greening Avenue in Mississauga. That particular property had a main floor, an upper floor, and then a basement area that was capable of being converted to rental purposes.

In 1988, the upper portion thereof was rented at $800.00 per month, and unfortunately in 1991 and 1992 and 1993, the rental market declined sufficiently that he was unable to get more than $515.00 a month for that particular unit.

The basement and other renovations and repairs cost more than initially anticipated, and the basement did not produce the kind of rent that was initially expected, because of the decline in the general rental market. And thereafter, because of the fact that there were increasing number of vacancies, despite his best efforts to screen tenants, on occasion he had tenants in the basement that caused him difficulties and led him to have the police assist during an eviction, and then attempt to collect money for back rent in small claims court for which he was not successful.

Basically, the appellant had only $104,000.00 mortgage on a property that was purchased for $204,000.00 because he was able to obtain from his mother an interest-free loan of $100,000.00. They were both on the title because he had been a recent graduate from university and was seeking employment at the time, and for mortgaging purposes, he and his mother were jointly on the title. But she signed a declaration of trust, which was filed with the court, indicating that she held a 50% legal interest as trustee for him, and that he was the 100% beneficial owner.

As it turned out, he did not in fact turn a profit for the years under review even after the inappropriate initial capital expenses were deleted from the claim for the loss.

The Federal Court of Appeal in recent times has issued several decisions in the area of reasonable expectation of profit. One of them was Tonn v. R. (1995), 96 D.T.C. 6001 (Fed. C.A.) . The Tonn case was referred to by the Federal Court of Appeal, and the case of Mastri v. R. (June 27, 1997), Doc. A-650-96, A-651-96 (Fed. C.A.) which was released by the court on June 27th, 1997.

In that particular instance, the judgment of the court was given by Mr. Justice Robertson who at page 6 stated, and I quote:

First, it was decided in Moldowan that in order to have a source of income, a taxpayer must have a reasonable expectation of profit. Second, ‘whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all the facts’. If as a matter of fact a taxpayer is found not to have a reasonable expectation of profit, then there is no source of income and, therefore, no basis upon which the taxpayer is able to calculate a rental loss. There is no doubt that, post Moldowan, this court has followed and applied that decision: see Landry v. Canada, 94 DTC 6624; Poetker v. Canada, 95 D.T.C. 5614; and Hugil v. Canada, 95 DTC 5311. The only remaining issue is whether Tonn departs from that jurisprudence by postulating that a reasonable expectation of profit test remains irrelevant to the question of deductibility of losses until such time as it can be established that the case involves an inappropriate deduction of tax, the presence of a strong personal element or suspicious circumstances. There are two passages in Tonn which are cited in support of that proposition of law and are worthy of reproduction (supra at 6009 and 6013):

The Moldowan test, therefore, is a useful tool by which the tax inappropriateness of an activity may be reasonably inferred when other, more direct forms of evidence are lacking.

Consequently, when the circumstances do not admit of any suspicion that a business loss was made for a personal or nonbusiness motive, the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgment may have been less than competent.

…] otherwise agree that the Moldowan test should be applied sparingly where a taxpayer’s ‘business judgment’ is involved, where no personal element is in evidence, and where the extent of the deductions claimed are not on their face questionable.

However, where circumstances suggest that a personal or other- than-business motivation existed, or where the expectation of profit was so unreasonable as to raise a suspicion, the taxpayer will be called upon to justify objectively that the operation was in fact a business. Suspicious circumstances, therefore, will more than often lead to closer scrutiny than those that are in no way suspect.

Mr. Justice Robertson then at page 7 of his judgment continues as follows:

In my respectful view, neither of the above passages supports the legal proposition espoused by both the Minister and the taxpayers. It is simply unreasonable to posit that the court intended to establish a rule of law to the effect that, even though there was no reasonable expectation of profit, losses are deductible from other income sources unless, for example, the income earning activity involved a personal element. The reference to the Moldowan test being applied ‘sparingly’ is not intended as a rule of law, but as a common sense guideline for the judges of the Tax Court.

In other words, the term ‘sparingly’ was meant to convey the understanding that in cases, for example, where there is no personal element, the judge should apply the reasonable expectation of profit test less assiduously then he or she might do if such a factor were present. It is in this sense that the court in Tonn cautioned against ‘second-guessing’ the business decisions of taxpayers. Lest there be any doubt on this point, one need go no further than the analysis pursued by the court in Tonn.

In Tonn, the court clearly held that no personal advantage had accrued to the taxpayer who was seeking to deduct rental losses from his other sources of income. Nonetheless, the court continued to pursue the deductibility of losses issue by applying the factors set out in Moldowan when assessing whether there was a reasonable expectation of profit. The court’s summary, provided at 6015, lays to rest any doubt as to what was decided in Tonn:

My disposition of this case is therefore as follows. The Tax Court judge erred in principle as well as in his application of the reasonable expectation of profit test, as it is now understood.

He did not consider all the factors he should have considered, nor did he assess the context fully. The evidence clearly showed that the taxpayers engaged themselves in a business enterprise and their expectations of profit were not unreasonable in the circumstances.

A small rental business was launched without the aid of a sophisticated market analysis at a time when the rental market looked promising. Soon after, as a result of unforeseen circumstances, it became precarious. No personal benefit accrued to the taxpayers by their rental arrangements. The property was not a vacation site. The house was not used to give free or subsidized housing to relatives or friends. They made an honest error in judgment and lost money instead of earning it.

It is not for the Department (or the court) to penalize them for this, using the reasonable expectation of the profit test, without giving the enterprise a reasonable length of time to prove itself capable of yielding profits.

In summary, the decision of this court in Tonn does not purport to alter the law as stated in Moldowan. Tonn simply affirms the common-sense understanding that it is not the place of the courts to second-guess the business acumen of a taxpayer whose commercial venture turns out to be less profitable than anticipated. Accordingly, the Tax Court erred in his understanding and application of Tonn.

Then, on July 28th, 1997, the Federal Court of Appeal released its decision in the case of Mohammad v. R. (July 28, 1997), Doc. A-652-96 (Fed. C.A.), and again Justice Robertson was the author of that particular decision.

Basically, the Mohammad case involved a situation where there had been 100% financing, and the tax Court Judge had found that a reasonable expectation of profit had existed. However, he used section 67 of the Income Tax Act to reduce the amount of expenses. That approach met with disapproval by Justice Robertson.

However, in the Mohammad case, as was pointed out on page 5 in the judgment of Justice Robertson, that was not a case where revenues fell below expectations. There was also a discussion therein as to what can happen to a taxpayer who, right from the start, impossibly burdens the rental venture by making too much interest charged against the revenue side of the equation.

That is not the case here. It is true that the property was 100% financed in the sense that his mother gave him a loan of $100,000.00, but there was no interest chargeable against the revenue side of the equation flowing from the property.

I recognize that, as it turned out, there was a personal element in the sense that he occupied the middle floor, but initially when the realtor was looking for an investment property for him, it was on the basis that all of it would be rented out. He was a single man, had been living with his mother and decided to physically occupy the premises, probably a wise decision having regard to the amount of renovations, and so on, that needed to be done.

Accordingly, while I recognize that there was a personal element, that element was very slight, and in any event, the calculations that were done by Mr. Hayashi, for the purpose of the expenses, adequately took that into account.

As I indicated, and bears repeating here, in the case of Howard v, R., [now reported, [1997] 2 C.T.C. 2458 (T.C.C.)], 96-895(IT), at page 12. I said there, and it is applicable here:

It should be kept in mind that in large metropolitan areas in Canada, it is almost inevitable that a young couple would require a property which is capable of producing some revenue in order that the purchase can be made initially and sustained thereafter under difficult circumstances in an uncertain economy. It is a fact of life which is well recognized by banks, other financial institutions, and all levels of government, especially municipalities, which are directly affected by housing shortages.

It is precisely that kind of rental accommodation flowing from thousands of mixed used properties which helps to narrow the gap between increasing demand and the supply provided by public housing or residential rental space in the form of apartment suites, townhouses and condominiums.

The occupation by the appellant, in this instance, of the middle floor makes it factually different than Tonn, but in my view it does not detract at all from the applicability of Tonn because the motivation to purchase the property and to seek it out in the initial instance was on the basis of emulating his mother by purchasing a good rental property in a rapidly rising market in Toronto. The appellant had attended Lakehead University, had been away from Toronto approximately three years, and in that period of time, generally speaking, the values of property had doubled.

In this instance, then, it is clear that for no fault of his own, revenue fell. Instead of getting $800.00 a month for the upper part of it, he was lucky to get $500.00, rising thereafter to only $515.00.

The basement, instead of producing a reasonable amount of $400.00 or $500.00 a month, produced sporadic rent because of people moving out on him, his inability to move someone out because that tenant was in jail, and otherwise running into the situation where, as opposed to 1988, an advertisement did not produce the numbers of responses that it had earlier. He would have preferred to sell the property, but in a rapidly declining market, that would not have been prudent.

Ultimately, he made a deal at the end of December 1994 with the date of closing in May of 1995, and he testified to taking all of the factors into account including his capital expenses. At best, he probably broke even.

In this instance, once the appropriate expenses were calculated, and nondeductible expenses eliminated, it presented a different factual picture.

I also indicated that I would not be allowing the expense of telephone, cable television, or bank charges as an expense against the rental income, and accordingly, a calculation was then made, at my request, to delete those expenses.

I want to repeat again that this is not a case of applying section 67, because section 67 applies only where certain expenses are otherwise deductible under the Act.

So looking at the overall picture, then, the property was not, for the purposes of taxation, 100% financed. The approach taken by the appellant to bring on-stream additional revenue was reasonable, although like most home owners, and property owners, he found the costs of renovations and adaptation more than initially anticipated.

His rent expectations were reasonable, but by 1991 he was not in any position, because of the overall market, to achieve the kind of rental that he otherwise would have been entitled to. He made a profit in 1994 because he made the decision in October of 1993, having been married in 1992, to use the upper flat for the use of he and his wife and thereafter to only have the basement as a rental property. That produced a profit. In 1995 there was a small loss because the year only went until the end of April as a consequence of him selling the property and turning it over in May.

Having regard to all the evidence, and all of the factors, and the jurisprudence that I have quoted, in my view, it would be an exercise in hindsight to deny the revised losses to the appellant, and I accordingly find that he did, in fact, have for the years under appeal a reasonable expectation of profit as defined within the jurisprudence, and especially in light of the modern jurisprudence emanating from the Federal Court of Appeal.

Accordingly, therefore, the appeal of the appellant is allowed for all taxation years, and the assessment is referred back to the Minister of National Revenue for reconsideration and reassessment on the following basis: That for the taxation year 1991, the Minister allow rental losses in the sum of $6,813.55; that in the year 1992, the Minister allow rental losses in the sum of $6,135.11; that in the taxation year 1993, the Minister allow rental losses in the sum of $5,353.52.

The level of success, while technically, perhaps, it is close to the 50% mark, taken overall, does not in my view entitle the appellant to an award of costs.

The claim as originally filed and as originally presented to the Minister and thereafter, until appropriate revisions were made, were such that the litigation was largely made necessary by the improper inclusion of capital and other items which were not deductible.

Accordingly, the appeal - as I indicated earlier - is allowed, but there will not be an award of costs made to the appellant. Thank you.

MR. HAYASHI: Thank you, Your Honour. HIS HONOUR: Thank you.

Appeal allowed.