McPherson v. R., [1998] 1 CTC 2968, 98 DTC 1062

Beaubier T.C.J.:

This appeal pursuant to the General Procedure was heard at Toronto, Ontario on September 8-12, 1997.

The Appellant testified. Her counsel also called Suzanne Hubbard, C.R.A., S.R.A., who qualified as an expert appraiser in general real estate, and Frank Kelly, F.C.A., who qualified as an expert to provide an opinion as to the basis of accounting under generally accepted accounting principles in Canada with respect to a transaction where:

An individual acquired a property with the intention of reselling it. Pending resale, the property was rented in order to recover some of the ongoing annual costs associated with its acquisition, maintenance and carrying charges. In the particular circumstances, the ongoing annual costs exceeded the rental income, leading to annual losses.

The Respondent did not call any witnesses.

The Appellant has appealed the disallowance of rental losses and a terminal loss she claimed for 1990, 1991 and 1992. She claims that she acquired a property to sell it at a profit and, pending sale of the property, that she rented it to help carry the costs.

The Appellant has a grade 11 education. After high school she worked in a bank sorting cheques and married Mr. McPherson. He owned a small sheet metal business. The Appellant took two bookkeeping courses and kept the business books from 1971 until. 1980 when he sold the business. In 1975 they purchased a 10 acre farm property. They sold it in 1978 when they purchased another 10 acre farm on property near Uxbridge, Ontario. They operated it as a business until they sold it at a profit in 1987. In 1987 they purchased an 80 acre farm property. Initially they operated a cow-calf farm. Now they operate a feed lot there. They still live on this property. The Appellant does the bookkeeping for this business. The 80 acre property was later transferred by the McPhersons to their corporation, Bledsoe Holdings Limited (“BHL”). In 1992 the McPhersons purchased another farm property near Peterborough which they rent.

From 1981 until 1986 the Appellant was a territory operations assistant in her area for McNeil’s Pharmaceuticals. For twelve months in 1988-89 she did accounting inputs for a local insurance firm on a part time basis. Since then she has also worked for TMT Air Systems and for Sears Canada Inc. on a part time basis.

The Appellant testified that in 1985 her daughter sold her condominium for fifty percent more than she had paid for it after owning it for three years. In August, 1986 the Appellant became a licensed real estate agent and commenced work for a Century 21 agency in the Stouffville area. She began selling local houses. She continued to hold a real estate agent’s license through 1990 inclusive. She earned a very modest income as a real estate agent.

The McPhersons were aware of others making profits on real estate sales in their area, which is near Toronto. They began looking at local houses to buy and sell at a profit. Mr. McPherson spoke about their interest to a local chiropractor, Mr. Demchuk, who said he had made money buying and selling Reemark condominiums. He invited them to a meeting in December, 1986, of about 25 people put on at Mr. Demchuk’s premises by Reemark/Westney Place Limited (“Reemark”). They attended. It lasted two hours. They received booklets about the Reemark firms, discussed the advantages and disadvantages of a large condominium development, its tax advantages and the profits being made in real estate. Reemark was promoting a high-rise condominium development in Ajax called Top of Westney. From Mrs. McPherson’s testimony it appears that they took away Reemark literature, a full set of the agreement forms (Exhibit A-1, Tab 9) and the projections of income, losses and tax deductions (Exhibits R-2, Tab 35 and R-l, Tab 30). They read them over. They indicate a proposed transfer date of September 1, 1988 or later.

On December 19, 1986, they attended a second Reemark meeting at Mr. Demchuk’s. On December 19, 1986, the McPhersons signed the documents and purchased two condominium units in the Top of Westney complex, 703 and 804. 804 is the subject matter of these appeals. It was purchased in their joint names for the Appellant. Both the Appellant and the Respondent acknowledge that unit 804 is the legal property of the Appellant and 703 is the property of Mr. McPherson. Exhibit R-2, Tab 34 is the agreement dated December 19, 1986 respecting 804. Despite the description of unit 804 as a “3A” unit in this agreement, it is acknowledged that the Appellant purchased a “C-II” unit.

The agreement consists of:

1. General Agreement with Reemark/Westney Place Limited.

2. Unit Purchase Agreement with Reemark/Westney Place Limited.

3. Trust Agreement with Reemark/Westney Place Limited.

4. Development Agreement with Reemark/Westney Place Limited. 5. Services Agreement with Reemark Group Financial Services Limited.

6. Rental Management Agreement with Reemark Group Management Services Limited.

7. Guarantee Agreement with Reemark Group Inc.

8. Appliances Lease with Reemark/Westney Place Limited.

The total price they committed to pay for 804 was $133,990, consisting of

They only paid $1,000 cash. The rest was financed by mortgages and promissory notes. They expected to receive title by September 1, 1988. The clause respecting this provided that it could be a later date and the Appellant understood this. (Exhibit R-2, Tab 34, Unit Purchase Agreement, page 14, paragraph (x)).

Reemark’s marketing examples describe an individual income tax rate of approximately 50% for deduction of the proposed rental losses (Exhibit R-2, Tab 30). Neither of the McPhersons was anywhere near that tax bracket. Mrs McPherson testified that they bought intending to sell as soon as possible. However, construction start-up was delayed. They visited the site bi-monthly and soon realized that it would not finish in time for a transfer of title by September 1, 1988.

On February 26, 1987, the McPhersons and some other purchasers obtained amendments to the agreements through a lawyer they had instructed (Exhibit R-2, Tab 35).

By late 1988 the McPhersons were visiting the building site more frequently. The Appellant phoned a Mr. Ziedenberg of Reemark who said that Reemark was commencing a resale programme for its Top of Westney condominium owners. Reemark sent McPhersons the particulars of this on January 26, 1989 (Exhibit A-1, Tab 12). On February 7, 1989 the McPhersons signed the resale agreements and returned them to Reemark (See Exhibit A-1, Tab 13). They agreed to sell 804 for $204,400. This price was set by Reemark. Mrs. McPherson testified that she would have preferred to offer a somewhat lower price. They visited the site every two weeks during the sales programme. The sales office for the resale programme was in one of the condominium units. By late March, 1989, the resale programme map in the sales office had “SOLD” marked on 804. A neighbour of theirs resold his Top of Westney Reemark condominium for the agreed amount and received his papers and completed his resale. By about June 15, 1989 the McPhersons learned that 804 was rented. They were surprised because they thought it had been sold. When they investigated they found that either there had been a mistake or that the sale had fallen through. 804 had been leased by Reemark as their agent for a three year term, from April, 1989 at $1,165 per month (Exhibit A-l, Tabs 15 and 16).

Title to 804 was transferred by Reemark to the McPhersons on May 31, 1990 (Exhibit A-1, Tab 21). At that time the McPhersons exercised their right to have Reemark continue to manage the rental of 804 and for it to remain in Reemark’s rental pool for three years. In late 1991 they learned that Reemark was not paying its bills as they came due. They saw their lawyer, Mr. Goodbrand, who wrote the Bank of Montreal which held the first mortgage to confirm that the property taxes were being paid to Ajax.

Despite the fact that she did not understand her Reemark agreements, for all practical purposes Mrs. McPherson locked herself into Reemark for three years when she received title on May 31, 1990 because Reemark had leased 804 and it was in the rental pool. Reemark controlled leasing and sales in Top of Westney due to its signage and its sales office at the premises, so this was her only practical course to obtaining any rent receipts. She continued to try and sell 804 from the time of Reemark’s resale programme in February, 1989 with a hiatus to be sure that she had a prospect of a title to transfer.

In about April of 1992 the Appellant and her husband took over the management of 804. Simultaneously Reemark offered the tenant of 804 an incentive to move. The tenant moved to a Reemark managed condominium. The Appellant and Mr. McPherson painted and renovated 804 to make it more marketable both to rent and to sell. (See Exhibit R-l, Tab 19, Item 5).

In late 1989 the McPhersons did not have title to 804 but they expected it by January, 1990. They listed 804 for sale with a Century 21 in Pickering, Ontario on November 20, 1989 for $189,900 (Exhibit A-l, Tab 17). On November 29, 1989 they offered to sell it to the tenant (Exhibit A-l, Tab 18), They continued to list with the same agent with occasional lapses in the listing, but reduced the asking price over time down to $112,000 on June 30, 1992 (Exhibit A-l, Tab 31). On September 23, 1992 they signed an offer to purchase for 804 for $108,000 (Exhibit A 1, Tab 32). The sale closed at that price on December 2, 1992 (Exhibit A-1, Tab 34),

Mrs. McPherson stated, and the Court accepts it as true, that neither she nor her husband purchased 804 or used it for their personal use.

The Appellant followed the promotional plan set out by Reemark. Each year Reemark sent her a statement of deductions respecting 804. These statements described rental losses which varied somewhat from the projections the McPhersons took from the meeting in December, 1986 (Exhibit R-1, Tab 30). Each year Mrs. McPherson filed her income tax return and claimed the deductions set out in Reemark’s annual statement. In cross-examination the Respondent’s solicitor pointed out to her that this treatment held 804 out as a capital property. In addition to rental losses, the 1986 promotion material shows annual increases in the value of the property which the appellant could realize on in 1997 using the $250,000 capital gains exemption.

When Mrs. McPherson sold 804 in 1992 she claimed losses as follows: In fact, part of the “UCC” was “land” valued at $13,000.

Mrs. McPherson was on the stand for two entire court days. Her reasoning, while somewhat inconsistent in technical legal and income tax terms, was consistent throughout her testimony. She testified, in essence, that she purchased 804 to sell it. She read Reemark’s material when she purchased it although it is clear to the Court on her testimony that she did not understand it entirely at that time. She received Reemark’s annual statements and filed them the way Reemark told her to do it. She claimed her annual losses on a rental basis.

Mrs. McPherson also relied on her accountants, Farm Business Consultants Inc., to file her loss claims properly when it took over the filing of her income tax returns. Commencing in 1993 when Farm Business Consultants Inc. were preparing her 1992 income tax returns, she became aware that one of its representatives did not fully understand the ramifications of her return. She says that she caught Farm Business Consultants Inc. lying to her during her negotiations with Revenue Canada and went elsewhere for ad- vice and representation to Revenue Canada. By this time her inconsistencies were fully documented to Revenue Canada.

Mrs. McPherson acknowledged that her claims of losses were in conflict with her intention to sell when she purchased. She testified that she did not purchase 804 with the intention of renting it. She stated that she and her husband were not in an income bracket to use the losses and this is true. Reemark’s examples use a 50% bracket. Mrs. McPherson was liable for a total income tax rate of about 15% to 20%. Despite the guarantees of the Reemark companies, some payments had to be made by the McPhersons. The Court accepts Mrs. McPherson’s testimony that she did not buy 804 with the intention of keeping it and renting it at a profit or renting it on any other basis, including using the losses proposed in the Reemark projections (Exhibit R-l, Tab 30). She said that she intended to sell 804 at a profit as soon as she could. Because the market was strong in 1986, Mrs. McPherson expected at the time that she purchased it that she could sell 804 at a profit. The Court also accepts her position that she rented it, when that proved necessary, in order to assist her meet the carrying costs.

Mrs. McPherson was a real estate agent. The market was strong when she purchased. She knew of other sales at large profits and wanted some of those profits. She knew that Mr. Demchuk stated that he had sold Reemark properties at a profit. A profitable tax free sale was held out in the Reemark literature using the $250,000 capital gains exemption

Using the list set forth by Major, J. in Friesen v. /?., [1995] 2 C.T.C. 369 (S.C.C.) at 375, the Appellant testified that she purchased 804 in 1986 with the intention of selling it as soon as possible. She financed all except $1,000 of the purchase price of $133,990. It does not appear to have been completed by the builder until some time at the end of 1988 or early 1989. She entered into Reemark’s resale programme on February 7, 1989, at the first opportunity at Reemark’s price of $204,400. According to Suzanne Hubbard this was at the very peak of the real estate market. Some of these condominiums were sold by Reemark. 804 did not sell and the Appellant discovered this in June, 1989. The Appellant listed 804 in November, 1989 (when she expected to receive her title within a reasonable time) for $189,900. Suzanne Hubbard testified that the market remained high throughout 1989. Then it fell.

Suzanne Hubbard testified that a realistic listing price on December 31, 1990 would have been about $145,000 when 804 had a fair market value of $132,000. On January 21, 1991 the Appellant relisted it for $164,900. Mrs. Hubbard stated that on December 31, 1991 a realistic listing price would have been $135,000 which was the listed price of 804 in September, 1991 and again in January, 1992. On December 31, 1991 the fair market value of 804 was $123,000 according to Mrs. Hubbard. The Court accepts this evidence in its entirety.

The Appellant’s only listing price that the evidence indicates was excessive is that of $164,900 in January, 1991. In the Court’s view, the original November, 1989 listing price of $189,900 was merely an attempt to seize any sales possibility that remained from Reemark’s resale programme at what turned out to be the top of the market. The rest of the listing prices were within range of what the evidence shows was happening to condominiums in Ajax. On the evidence, the Appellant was trying to sell 804 as soon as she could offer title in what became a dramatically falling market. She made a natural attempt to get the best price possible in Ajax’s thin and falling condominium market. Her activities confirm a consistent effort to sell having regard to construction, the availability of title and the constraints of the Ajax market. Her leasing programme with Reemark was merely an attempt to alleviate her burden of carrying 804. The Appellant had become a licensed real estate agent when she purchased and continued this calling into 1990. She made no personal use of the property. It was rented by Reemark when she thought it was sold and she kept the tenant when she received title. The purchase was based on borrowed money to an extent of more than 99% of the price.

Mrs. McPherson has an above average knowledge of income tax which, from her farming property transactions, has increased since 1986. The Court is of the view that she understood the concepts contained in her rental loss claims including the fact that the condominium was being held out to Revenue Canada as a capital property. She also understood that its rental was being held out to Revenue Canada as a for-profit enterprise. Despite her claims to Revenue Canada, Mrs. McPherson intended to “flip” 804 from the beginning. But she did not ever intend to rent it at a profit. No penalties were assessed against the Appellant, so the Court is not required to determine any degree of negligence or deliberation respecting the Appellant’s acts.

Respondent’s counsel argued that estoppel should apply against the Appellant’s claim for a loss on her “flip” on the basis that her income tax returns held 804 out as a capital property on which she could deduct rental losses. The Minister of National Revenue allowed those losses from 1986 until 1990. Therefore, the Minister of National Revenue had acted to his detriment based upon the losses claimed by the Appellant in her income tax returns. The Respondent’s argument fails because the Appellant’s description of 804 as capital was a statement of law and not of fact. (By comparison her losses claimed were, in fact, losses.) Had she sold 804 at a profit in 1992, the facts indicate that the profit would have been taxable income and the Respondent’s assessments allowing rental losses would not have estopped such an assessment against the Appellant.

For the foregoing reasons and on the facts described, the Court finds that the Appellant purchased 804 with the intention of reselling it at a profit and that she had a reasonable expectation of selling 804 at a profit when she purchased it in December, 1986. On the evidence, it was a one-time transaction. Her efforts to sell it were business-like. Thus, it was an adventure in the nature of trade. 804 constituted inventory. However, the Appellant did not intend to profit from renting 804. Rental profits were not held out to her by Reemark; losses were. She never rented 804 at a profit. On the evidence, the Appellant had no reasonable expectation of profit from renting 804 at any time. For these reasons, the Appellant cannot deduct her alleged “rental losses” from her income in 1990, 1991 and 1992. She was not in the business of renting 804.

For the years in question, the following portions quoted from the Income Tax Act are germane:

248(1) “business” includes a profession, calling, trade, manufacture or undertaking

of any kind whatever and, except for the purposes of paragraph 18(2)(c), section 54,2 and paragraph 110.6(14)(f), an adventure or concern in the nature of trade but does not include an office or employment;

“inventory” means a description of property the cost or value of which is relevant in computing a taxpayer’s income from a business for a taxation year or would have been so relevant if the income from the business had not been computed in accordance with the cash method and, with respect to a farming business, includes all of the livestock held in the course of carrying on the business;

9 (1) Subject to this Part, a taxpayer’s income for a taxation year from a

business or property is the taxpayer’s profit from that business or property for the year.

(2) Subject to section 31, a taxpayer’s loss for a taxation year from a business or property is the amount of the taxpayer’s loss, if any, for the taxation year from that source computed by applying the provisions of this Act respecting computation of income from that source with such modifications as the circumstances: require,

(3) In this Act, “income from a property’’ does not include any capital gain from the disposition of that property and “loss from a property’’ does not include any capital loss from the disposition of that property.

10 (1) For the purpose of computing income from a business, inventory

shall be valued at its cost to the taxpayer or its fair market value, whichever is lower, or in such other manner as may be permitted by regulation.

Frank Kelly, F.C.A., who was called as an expert accounting witness by the Appellant, expressed his opinion in his report as follows:

My Opinion

I understand that in the transaction previously described, property was acquired with the intention of resale.

In my opinion, assuming the facts support the intention, this property would be properly classified as inventory under generally accepted accounting principles in Canada.

In my opinion, the inventory would be stated at the lower of cost and net realizable value under generally accepted accounting principles in Canada.

In my opinion, to the extent costs exceeded net realizable value in any one period, the difference would represent an expense for the period under generally accepted accounting principles in Canada.

In my opinion, either one of the following would be an appropriate basis of accounting under generally accepted accounting principles in Canada for the lower of cost and net realizable value:

1) Capitalization of costs up to net realizable value only, with the excess recorded as expense of the period; or

2) Continued capitalization of costs offset by a provision for loss to the extent required to arrive at net realizable value, with the provision for decline recorded as an expense of the period.

Mr. Kelly’s opinion is based in part upon his readings from The Canadian Institute of Chartered Accountant’s Handbook and The Canadian Institute of Public Real Estate Companies Handbook. The accounting practice 1s, of course, subject to subsection 10(1) of the Income Tax Act as quoted.

In Friesen, ibid, Major, J. stated at pages 384 and 5:

In summary, I conclude that the valuation method in subsection 10(1) is available for inventory held as part of an adventure in the nature of trade. The valuation method becomes relevant in any particular taxation year through the calculation of business income. Business income is calculated according to well- accepted commercial and accounting principles. According to these principles the value of inventory is relevant to the computation of income in years prior to sale since it comprises part of the cost of sale. According to the same principles inventory is to be valued at the lower of cost or market value, a specific exception to the general principle of realization. This exception is well accepted in the

specific instance relevant to this appeal: the valuation of real estate inventory. This conclusion is fully consistent with the line of cases following Bailey. As Cullen J. states in Van Dongen at page 6639:

The later Bailey case appears to have settled the issue that land held as an adventure in the nature of trade is eligible for inventory writedown.

See also: Weatherhead, Skerrett, and Cull, supra

At page 389 Major, J. said:

In 1989, Regulation 1801 was amended to read:

1801. [Valuation] Except as provided by section 1802, for the purpose of computing the income of a taxpayer from a business, all the property described in all the inventories of the business may be valued at its fair market value.

The 1989 amendment removed from the taxpayer the option of choosing to value inventory at historical cost and left only the more conservative methods of fair market value or the lower of cost or market value. The practical effect of this amendment is that in years following 1989 the taxpayer must declare a loss for taxation purposes in any year in which the fair market value of inventory falls below historical cost. The taxpayer no longer has the option of postponing this loss until the taxation year in which the loss is actually realized upon sale of the inventory. This is made clear in the “Regulatory Impact Analysis Statement” published along with the amended regulation, SOR/89-419

From 1990 to 1992 the Appellant reported rental income, expenses and losses from 804 as follows:

The calculation of “cost” of 804 is to be made on an annual basis. The calculations set out by the Respondent in argument are as follows: less costs deducted in that year

1992

The position taken by the Respondent for the years 1988 and 1989 is incorrect. For example, the Respondent’s calculations in 1988 describe “less service costs deducted in that year that reduced the cost $1,550”. They refer to landscaping and repairs of $1,250 and legal and accounting of $300 for a total of $1,550. However, the Appellant deducted $9,066 as costs incurred in fact which were allowed by the Minister of National Revenue’s assessment for 1988. In the Court’s view, the Appellant is estopped from denying this as her cost based upon the fact that she claimed $9,066 as her cost and it was accepted by the Minister of National Revenue to his detriment. On the facts found, it constitutes cost of inventory. The $9,066 consists of:

TOP OF WESTNEY

ADMINISTRATIVE AND SERVICE FEE

On this basis the Court finds that the $9,066 deducted by the Appellant in 1988 is cost of inventory which in fact reduces the 1987 year end costs of $123,470. For the same reason the Court applies the Appellant’s deductions claimed respecting 804 in the years through 1989, which were not subject to reassessment and appeal, as cost of inventory.

On the other hand, the Respondent’s calculations for 1990, 1991 and 1992 constitute the basis upon which the Minister proposed to reassess the years in appeal if 804 is found to have been purchased to sell as inventory. Therefore the Respondent’s calculations from 1990 onwards are accepted. For these reasons, the Court has recalculated the Respondent’s submissions as follows:

For the foregoing reasons the appeals are dismissed for the years 1990 and 1991. The appeal in respect to 1992 is referred to the Minister of National Revenue for reconsideration and reassessment on the basis that the Appellant’s inventory loss to be allowed for 1992 is $28,787.30.

Success is divided. The parties have asked that they be allowed to submit further argument in respect to costs. The Registrar will contact counsel for the parties within seven days from the date of this judgment for the purpose of fixing a time for a telephone conference so that procedures respecting the argument can be arranged.

Appeal allowed in part.