Makis Construction Limited v. Minister of National Revenue, [1972] CTC 2082, 72 DTC 1101

W O Davis:—This appeal, which was heard before me at Toronto, Ontario, on September 27 and 28, 1971, at a sittings of the Tax Appeal Board as it was then constituted, is from a reassessment to income tax dated April 10, 1970, in respect of the appellant’s 1967 taxation year ended December 31. In assessing the appellant, the Minister of National Revenue included as part of the appellant’s income from its business a profit realized by it in its 1967 taxation year on the sale of an apartment building on June 13,1967.

In its notice of appeal, the appellant contends that the said profit of $219,538.81, which figure is not in dispute, did not, in the relevant circumstances, constitute income of the appellant from its business within the meaning of sections 3, 4, and paragraph 139(1)(e) of the Income Tax Act.

However, the appellant does contend that, in the event that the said profit should be found to be income subject to tax, it is entitled to a reserve (under the provisions of paragraph 85B(1)(d) of the Act) in the amount of $186,982 instead of the reserve of only $131,000 allowed by the Minister in the assessment now under scrutiny.

In his reply to the appellant’s notice of appeal, the respondent declined to accept the appellant’s contentions in view of the following assumptions of fact upon which, inter alia, he had relied when assessing the appellant as he did:

(1) That at all times material to this appeal, the appellant was in the business of building and trading in real estate and that Hazel Mallett and Victor Kirby, the appellant’s two shareholders, had been active in the real estate business for some considerable period prior to the incorporation of the appellant;

(2) That in early 1959, prior to the incorporation of the appellant, the said Hazel Mallett and Victor Kirby had acquired approximately 3 acres of vacant land situated at Birchmount Road and Lawrence Avenue, Toronto, which, following the incorporation of the appellant, they had transferred to it;

(3) That the appellant had constructed a shopping plaza on approximately one-half of the said vacant land, the construction of which had been completed during the month of September 1959;

(4) That on or about October 23, 1959, Hazel Mallett and Victor Kirby caused Birch-Lawr Investments Limited to be incorporated, with each of them owning a 50% interest therein, and that on that same day the appellant sold the said shopping plaza to Birch-Lawr Investments Limited at a profit of approximately 10% of costs;

(5) That on completion of the construction of the said shopping plaza, the appellant commenced the construction of the said apartment building on the remaining portion of the said vacant land acquired by it and that, on completion of the construction, it was the appellant’s intention to transfer the said apartment building to: Birch-Lawr Investments Limited;

(6) That at all times material to this appeal, the appellant’s investment in the said apartment building was less than 5% of its costs;

(7) That the construction of the said apartment building was completed prior to December 31, 1960, and that as of that date the said apartment building was subject to two mortgages in the amounts of $330,- 625 and $71,962 respectively;

(8) That during the period 1960 to 1967 the appellant suffered sizable losses on the rental of the said apartment building in all but one of those years;

(9) That the appellant acquired the said vacant land and constructed the said shopping plaza and the said apartment building thereon with a view to trading, developing or otherwise turning them to account at a profit in the course of carrying on its business and in pursuance of its objects; and

(10) That the appellant’s profit on the sale of the said apartment building was in the amount of $219,538 and that as part of the purchase price the appellant received a mortgage on the said apartment building in the amount of $167,500.

The appellant was incorporated in 1959 under the provisions of the laws of the Province of Ontario, following which it carried on business as a builder and construction contractor. The objects of the appellant company as set out in its letters patent are extremely broad in scope and include, in addition to the usual sweeping objects of builders and contractors, the power: “To purchase, lease, take in exchange or otherwise acquire lands or interests therein . . . and to sell, lease, exchange, mortgage or otherwise dispose of the whole or any portion . . . and to take such security therefor as may be necessary.”

The shareholdings of the company at its incorporation were divided equally between one Victor Kirby and one Hazel Mallett. Prior to the appellant’s incorporation, Victor Kirby, who was unquestionably the prime moving spirit with regard to the formation of the appellant company, had spent a number of years as a real estate salesman in London, Ontario, having been employed by several established real estate brokers. He subsequently moved to Metropolitan Toronto, where he again found employment with a series of established real estate brokers.

Around 1957, Mr Kirby and his associate Mrs Hazel Mallett, who at that time was similarly employed in the sale of real estate, decided that they would set up a real estate brokerage partnership of their own under the name and style of Kirby and Mallett. This venture appears to have gone well and to have shown encouraging prospects for the future.

In 1958 Mr Kirby seemingly felt that the time was ripe to venture into the development of substantial tracts of raw land, and he succeeded in obtaining a one-year option for the purchase of approximately 3 acres of land situated at the intersection of Birchmount Road and Lawrence Avenue in Metropolitan Toronto, for the price of $75,000. At the expiration of one year, Mr Kirby was unable to take up the option for lack of necessary funds, and succeeded in negotiating a 3-month extension thereof in return for a $10,000 increase in the purchase price. During this 3-month extension, Mr Kirby was able to arrange a loan which enabled him to exercise his option and complete the purchase of the said vacant land, and it was at this stage that the appellant company was incorporated for the purpose of taking title to the land so purchased.

The minutes of a meeting of the directors of the appellant company held on May 28, 1959 (Exhibit R-2), at which Mr Kirby, the president of the company acted as chairman, record the following:

The Chairman advised the meeting that he and Mrs Mallett had entered into a contract with one E R Meredith in November of 1958, for the purchase of land on Birchmount Road, composed of part of Lot 30, Concession D, Township of Scarborough for the price of $85,000.00 and the transaction had been financed by the giving back of a first mortgage to the vendor for $45,500.00 and the arranging of a second mortgage on the property for $40,000 to Bloor Danforth Agencies Limited. The deed to Mr Kirby and Mrs Mallett had been taken in their names as Trustees of a company to be formed, namely Makis Construction Limited, and the mortgages had been given back in the same manner.

The Chairman advised that with the organization of the company complete, it was in order now to convey the property into the name of the company and for the company to assume the outstanding mortgages.

Immediately following completion of the said conveyance, the necessary funds for construction were secured by a mortgage loan and a start was made on the construction of a 12-store shopping plaza on the northerly part of the 3-acre parcel. The plaza was completed around October 1959 and tenants were obtained and moved into the various stores comprising the shopping plaza with little delay.

At this stage, a new company, known as Birch-Lawr Investments Limited, was incorporated on the advice of the lawyers and accountants of Mr Kirby and Mrs Mallett, and the shopping plaza was transferred to the new company, in which Mr Kirby and Mrs Mallett each held an equal interest. No question arises in these proceedings with respect to the shopping plaza venture.

Makis Construction Limited next turned its attention to the construction of a 6-storey 68-unit apartment building on the remaining land in the southern portion of the property, an area with a frontage of 225 feet on the east side of Birchmount Road and a depth of 350 feet. Once again it became necessary to find the necessary funds, and the appellant had to borrow money for this construction at rather high rates of interest. Consequently, it was necessary to settle for a loan of $330,000 where $400,000 had originally been envisaged and sought.

On or about June 29, 1960, when the apartment building was nearing completion, differences appear to have developed between Mr Kirby and Mrs Mallett, who, throughout all these construction developments, had continued to operate their real estate brokerage business. The disagreement was eventually resolved by Mr Kirby agreeing to buy out Mrs Mallett’s interest in Makis Construction Limited (the appellant), in Birch-Lawr Investments Limited, and in the real estate brokerage partnership for a total consideration of $60,000. To accomplish this, it was necessary for the shopping plaza to be sold to outside interests. This was done, and Mr Kirby and Mrs Mallett then went their respective ways, Mr Kirby being left as the sole shareholder of the appellant company, which, in turn, owned the apartment building, construction of which was completed in October of 1960.

The financial statements of the company show that the subscribed capital of the appellant was some $504, the construction having been financed by means of mortgage funds and bank loans. Clearly the apartment building venture had been embarked on with even less than border-line financing.

Mr Kirby experienced difficulties in his operation of the apartment building and, being without funds himself after buying out Mrs Mallett, was compelled to sell his home and utilize the proceeds of the sale to meet accruing expenses. He and his family moved into one of the units of the apartment building and he himself undertook the duties of building superintendent, janitor and general handyman. The rents were not sufficient to meet taxes and mortgage payments and Mr Kirby finally reached the stage where, in his desperate efforts to stem the tide, he was forced to borrow additional funds at extremely high interest rates. One such loan was arranged through a Mr Frank Martin with interest payable at 20%.

In or about 1967, Mr Kirby approached Mr Martin in connection with his financial difficulties. Mr Kirby said in evidence that he had gone to Mr Martin because, in the course of negotiating the aforementioned loan, Mr Martin had expressed a desire to buy the apartment building. On that occasion Mr Kirby had refused to sell, hoping he might be able to weather the gale and retain the building, even in the face of a badly depressed real estate market. However, when Mr Kirby’s doctor advised a move to a warmer climate for the sake of Mrs Kirby’s health and Mr Martin had again expressed a desire to purchase the apartment for about $100,000 more than he had previously offered, Mr Kirby, as president of the appellant company, decided that the time had come to sell, and did so.

On June 13, 1967, the appellant company, of which Mr Kirby was by then the sole shareholder, accepted from Frank Martin, as trustee for a company yet to be formed, an offer to purchase the apartment building at 1255 Birchmount Road for $680,000 payable as follows: $10,000 as a deposit and the purchaser to assume an existing first mortgage for $400,000 and to pay to the existing second mortgagee, to be applied pro tanto on account of the purchase price, an amount of $85,000 with interest accrued to the date of closing, in full discharge of the second mortgage, the purchaser further. agreeing to give back and the vendor agreeing to accept a new second mortgage in the principal amount of $170,000. The balance of some $15,000 of the purchase price was payable on closing but subject to adjustment at that time.

Having considered the evidence herein as I have understood it, and having taken cognizance of the fact that Mr Kirby, who was one of the two original shareholders and finally the sole. shareholder of the appellant, had been active in the real estate business from 1952 to 1967, and having also taken into account the fact that throughout the entire project with which this appeal is concerned the appellant company possessed no funds of its own with which it might be said to have established an investment, I have formed the opinion that the appellant, in pursuance of the objects for which it was incorporated, acquired the land referred to herein and constructed the said shopping plaza and apartment building thereon with a view to trading, developing or otherwise turning the same to account at a profit in the course of carrying on its business, and to do so just as soon as a favourable opportunity presented itself.

In so far as the expressed intentions of Mr Kirby are concerned, what is of importance is what actually happened. The post facto statements of the appellant with regard to the purpose for which the company was incorporated must be looked at through the filter of events and in the light of what actually took place.

My conclusion is that the profit arising from the sale of the apartment building was income of the appellant arising from its business and therefore subject to taxation as such. (In this connection, useful reference may be had to such cases as Lars Willumsen v MNR, [1968] 2 Ex CR 257, [1967] CTC 13, and Gerard Alain v MNR, [1971] Tax ABC 1100.)

In assessing the appellant under paragraph 85B(1)(d) of the Income Tax Act, the Minister of National Revenue allowed the appellant a reserve of $131,000 in respect of the mortgage given by the purchaser to the vendor (the appellant herein) -upon the sale of the apartment building on Birchmount Road. The appellant has complained that this reserve is less than it is entitled to, contending that such reserve should have been in the amount of $186,982.

The relevant statutory provision, as applicable to the 1967 taxation year, reads as follows:

85B. (1) In computing the income of a taxpayer for a taxation year,

(d) where an amount has been included in computing the taxpayer’s income from the business for the year or for a previous year in respect of property sold in the course of the business and that amount or a part thereof is not receivable,

(i) where the property sold is property other than land, until a day that is

(A) more than 2 years after the day on which the property was sold, and

(B) after the end of the taxation year, or

(ii) where the property sold is land, until a day that is after the end of the taxation year,

there may be deducted a reasonable amount as a reserve in respect of that part of the amount so included in computing the income that can reasonably be regarded as a portion of the profit from the sale;.

In a letter written to Mr Kirby by his attorneys, Messrs Siegal, Fogler and Greenglass (Exhibit R-4), following the completion of the sale of the apartment building to Mr Martin, to which letter there was attached a statement of adjustments made as of July 11, 1967, on the closing of the sale, it is set out that the existing first mortgage which was assumed by the purchaser stood at $397,178.10 with accrued interest of $1,544.81; the existing second mortgage owing to Mr Fogler, which was paid off and discharged by the purchaser as part of the purchase price, stood at $86,157.40; and the mortgage given back by the purchaser to the vendor and which, in the turn of events, then became the existing second mortgage, was for the amount of $170,000.

In computing the amount of the reserve to be granted to a vendor, it is important to bear in mind that such a reserve under paragraph 85B(1)(d) is only allowable in respect of the profit element in the amount receivable. The only requirement in regard to the allowable amount of a reserve in respect of the profit element in such a receivable is that the reserve must be a reasonable amount. In practice, it is considered reasonable to assume that the percentage of any amount of the sale price receivable in a subsequent taxation year that should be taken to represent the profit element included in the said receivable would be the same percentage of that receivable as the gross profit is of the total sale price. Conceivably a reserve might be allowed equal to the full amount of the profit so determined if no portion at all of the selling price had been received in the year of sale. Stated as a formula, the foregoing would be expressed as:

A modification of this formula is called for in a situation where an existing mortgage (or mortgages) is assumed by the purchaser, provided that none of these assumed mortgages has been placed on the property subsequent to the completion of the building so as to reduce the owner’s existing equity in the property. In such a case, the mortgage or mortgages so obtained are disregarded in calculating the reserve. In the case of the assumption of an existing mortgage by the purchaser, the above formula is modified by changing the denominator from the amount of the gross selling price to the difference between the gross selling price and the amount of the mortgage or mortgages taken out on the building during construction and later assumed by the purchaser. The formula then becomes:

In the instant matter, the evidence was that the modified formula was used. In calculating the actual amount of the reserve allowed, the following figures were applied to the formula:

For ease of calculation, the mortgage assumed was rounded upward to $400,000, thus resulting in the following equation:

’ - x $167,500 = $131,152 $680,000 minus $400,000

The amount thus arrived at was then rounded off at $131,000, which amount was allowed to the appellant as a reserve under paragraph 85B(1)(d).

It will be observed that, in computing the denominator of the above fraction, the Minister deducted from the gross selling price only the first mortgage, and ignored the second mortgage existing at the time of the sale in the amount of $86,200 which had been placed on the property subsequent to completion of the building and without increasing the existing value of the property. According to the evidence, the Minister took this position because the then existing second mortgage was immediately discharged by the purchaser in the course of closing the transaction so that, in fact, the appellant took a second mortgage in the amount of $167,500 from the purchaser.

Having examined the manner in which the Minister has computed the amount of reserve to be allowed to the appellant herein, I am satisfied that he has correctly interpreted and applied the rather complicated provisions of paragraph 85B(1)(d) of the Income Tax Act and that the amount of $131,000 fixed as a reserve is a reasonable amount to be allowed in the circumstances.

The amount of $186,982 contended for by the appellant as a reserve is, in my opinion, unreasonably high in the circumstances.

All things considered, the appeal fails and is dismissed.

Appeal dismissed.