Date: 20020403
Docket: 2001-3048-IT-I
BETWEEN:
MARK A. RAEGELE,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasonsfor Judgment
Miller, J.T.C.C.
[1] Mr. Mark Raegele appeals, by way of Informal Procedure, the Minister's reassessment of Mr. Raegele's 1998 taxation year. The Minister disallowed the deduction of expenses incurred by Mr. Raegele in repairing damages to his premises left by a tenant who moved out on July 15, 1998. Mr. Raegele moved into the property on August 12, 1998. He maintains the expenses were incurred wholly in connection with the repairing of the damages and as such are deductible. The Respondent, while agreeing that the expenses were incidental to the rental of the property, argues that they cannot be deducted due to the application of paragraph 18(1)(a) of the Income Tax Act ("Act"), as they were not incurred for the purpose of producing income.
[2] Mr. Raegele is a Lieutenant Colonel in the Canadian Armed Forces. He was posted to the United States in July, 1994. He rented his home at 1554 Sunview Drive in Orleans for the period of his tour of duty in the United States from August, 1994 to July 15, 1998. In May, 1994 Mr. Raegele and his wife entered a lease with Mr. and Mrs. Krishnarajan for an initial term of three years, later extended for just under a year to July 15, 1998. Some terms of the lease are as follows:
14. The Tenant:
...
d. covenants that he will indemnify the Landlord and any other Tenant of the said premises against any loss, costs or damage by reason of any neglect, carelessness or injury caused by him, any member of his family or household, any guest or other person on the rented premises with his consent, or by reason of non-occupancy, and for all damages caused by his dog (mini Schnauzer);
...
f. covenants to leave the premises clean and in good condition, and the carpets cleaned, on the termination of the tenancy.
and in the Rules and Regulations as follows:
5. The Tenant shall:
...
c. at all times keep the rented premises in a proper state of cleanliness including cleaning and maintenance of any floors, and proper care and cleaning of any carpets provided;
...
e. not use spikes, hooks, screws or nails on the walls or woodwork, except those necessary to hang normal and generally acceptable wall decorations;
[3] Upon their return to Canada in April, 1998, the Raegeles were dismayed to discover the state of their home, which Mrs. Raegele described as unliveable. The worst damage was to the flooring in the home which arose due to the tenant's dog's unfortunate, but evidently unrelenting, habit of urinating throughout the house. The uric acid seeped through the carpet into the sub-flooring, which required bleach to be scrubbed on the surface itself after removing the carpet. The kitchen and family room were layered with grease arising from four years of food preparations by the tenant with no sign of follow-up cleaning. The yard was overgrown and generally the place was filthy. The Raegeles requested their property manager to start looking into the cost of repairs.
[4] Mr. Raegele indicated that he telephoned the tenant on several occasions to clean the house. The tenants did show up at one stage after they had moved out to do so, but the visit was brief with nothing accomplished other than the tenants' agreement to pay for some window cleaning. As well as the extensive damage, the tenants had also left a water bill unpaid. Only after a number of requests was this bill paid. Mr. Raegele testified that he felt the tenant was in breach of the lease, but that the cost and effort to pursue the tenant would outweigh the benefit to be gained.
[5] The expenses at issue are set forth in Schedule A to the Respondent's Reply, which is attached. The dates indicate that all but the first expense were paid after the tenants moved out. It is of note however that the Appellant received an invoice for certain flooring work from Multi-Flooring Inc. for $7,917, which was dated in May, 1998 although the work was not completed until after the tenants departed on July 15th. Such invoice was ultimately paid on August 23, 1998. I find that the timing of the work and the entering into contracts for the work took place between mid-May and mid-August. The nature of the expenses are primarily in connection with the flooring (approximately $13,000) and painting (approximately $5,000). The Appellant did not claim for part of the hardwood flooring expense recognizing it was an upgrade constituting a personal benefit. He reduced the claim on that particular invoice by approximately $2,000.
[6] The Appellant's agent relies on subsection 9(1) and (2) of the Act which read:
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.
[7] He maintains expenses that are linked to the revenue-generating activities in a cause and effect relationship are acknowledged in the accounting period in which the revenue is recognized. This principle he propounds from the CICA Handbook. He further refers me to the Exchequer Court case of Dominion Natural Gas Co. v. M.N.R.,[1940-41] C.T.C. 144, although later reversed, which stated:
The generally recognized rule as regards trade expenses is that a deduction is permissible when it is justifiable on business and accountancy principles, but the principle is subject to certain specific statutory provisions which prohibit the allowance of certain expenses as deductions in computing the net profit or gain to be assessed. To the extent that ordinary business and accountancy principles are not invaded by the statute, they prevail.
[8] The Appellant's agent also referred to Justice Stone's statement[1] in Her Majesty the Queen v. Canderel Limited, 95 DTC 5101 at 5102:
In my view, the matching principle of accounting has, at least in this Court, been elevated to the status of a legal principle. The principle was best expressed by MacGuigan, J.A. in West Kootenay Power and Light Company Limited v. The Queen (1991), 92 DTC 6028, at pages 22 (6028):
The approved principle is that whichever method presents the "truer picture" of a taxpayer's revenue, which more fairly and accurately portrays income, and which "matches" revenue and expenditure, if one method does, is the one that must be followed.
[9] Finally the Appellant referred me to Gordon Kenneth Daley v. Minister of National Revenue, 50 DTC 877 and specifically the following passage:
That being so, it follows that in some cases the first enquiry whether a particular disbursement or expense is deductible should not be whether it is excluded from deduction by section 6(a) or section 6(b) but rather whether its deduction is permissible by the ordinary principles of commercial trading or accepted business and accounting practice. If the answer to such enquiry is in the negative then that is the end of the matter and it is not necessary to make any further enquiry, for it would then automatically fall within the exclusions of section 6(a) and it would not be necessary to consider whether it would fall within those of section 6(b).
[10] In addressing the application of paragraph 18(1)(a) of the Act the Appellant's agent stressed that the expenses cannot be viewed in isolation, but must be seen as part of the whole year's operation. Implicit in his argument is that the Appellant's business continued after the tenant moved out, albeit only to the extent of dealing with damages flowing from the rental operation.
[11] The Appellant recognized that some of the expenses would relate to his personal benefit and suggested an arbitrary 85% allocation of the expenses to business and 15% allocation to personal benefit. Finally, the Appellant's agent presented an argument which he did not pursue forcefully. He suggested that had a financial statement been prepared for Mr. Raegele for the month ending July 31, 1998, a reserve for doubtful accounts would have been set up to reflect the work required to repair the damage, which the Appellant believed was owed by the tenant. The Appellant's agent argues that by year-end the debt purported to be owed by the tenant had indeed become bad and should consequently be written off in accordance with paragraph 20(1)(p) of the Act.
[12] The Respondent's position quite simply is that the expenses at issue were not incurred for the purpose of earning income from property and therefore were not deductible in accordance with paragraph 18(1)(a). In the pleadings the Respondent also indicated that such expenses were personal or living expenses of the Appellant pursuant to paragraph 18(1)(h). The Respondent went so far as to agree that the expenses in issue were connected to the rental operation and were indeed reasonable, however, given that the Appellant admitted that the purpose the expenses were incurred was so he could live in the property, this did not meet the purpose requirements set out in paragraph 18(1)(a). When put to counsel for the Respondent that this strict reading of the section would preclude the deductibility of any expenses incurred by a business in a winding-up phase, if there was no longer a purpose to earn income, Respondent's counsel acknowledged that indeed would be the Respondent's position.
[13] Before reviewing the application of paragraphs 18(1)(a) and (h) of the Act, I wish to deal with the Appellant's argument regarding the deduction of a bad debt. Paragraph 20(1)(p) of the Act reads as follows:
20(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:
...
(p) the total of
(i) all debts owing to the taxpayer that are established by the taxpayer to have become bad debts in the year and that have been included in computing the taxpayer's income for the year or a preceding taxation year, and
This section requires for its applicability that the debt has been included in the taxpayer's income for the year. Even if I were to accept that the tenants' indemnity contained in the lease constituted a debt owed to the Appellant, such debt had not been included in the taxpayer's income for the year. Frankly I see this bad debt argument as something of a red herring. The issue is not the deductibility of a debt gone bad, but of the very real expenses incurred by the Appellant in the summer of 1998. It is these expenses which I must determine qualify for deductibility. In making that determination I find it is significant that Mr. Raegele believed it was the tenants' responsibility to honour their indemnity contained in the lease.
[14] I agree with the Appellant that based on ordinary commercial principles and accounting guidelines, the expenses at issue have created a loss. But are ordinary commercial principles sufficient to justify the deduction of the Raegles' repair expenses against their income from the property? Justice Iacobucci stated the following in the Canderel case:
Ordinary commercial principles dictate, according to the decisions, that the annual profit from a business must be ascertained by setting against the revenues from the business for the year, the expenses incurred in earning such revenues.
31 Accepting this fundamental definition, in Symes, supra, at pp. 722-23, the majority made the following observations about the computation of profit:
. . . the "profit" concept in s. 9(1) is inherently a net concept which presupposes business expense deductions. It is now generally accepted that it is s. 9(1) which authorizes the deduction of business expenses; the provisions of s. 18(1) are limiting provisions only. . . .
Under s. 9(1), deductibility is ordinarily considered as it was by Thorson P. in Royal Trust, [Royal Trust Co. v. Minister of National Revenue, 57 D.T.C. 1055 (Ex. Ct.)] (at p. 1059):
... the first approach to the question whether a particular disbursement or expense was deductible for income tax purpose was to ascertain whether its deduction was consistent with ordinary principles of commercial trading or well accepted principles of business ... practice ... (Emphasis added.)
Thus, in a deductibility analysis, one's first recourse is to s. 9(1), a section which embodies, as the trial judge suggested, a form of "business test" for taxable profit.
This is a test which has been variously phrased. As the trial judge rightly noted, the determination of profit under s. 9(1) is a question of law: Neonex International Ltd. v. The Queen.... Perhaps for this reason, and as Neonex itself impliedly suggests, courts have been reluctant to posit a s. 9(1) test based upon "generally accepted accounting principles" (G.A.A.P.).... Any reference to G.A.A.P. connotes a degree of control by professional accountants which is inconsistent with a legal test for "profit" under s. 9(1). Further, whereas an accountant questioning the propriety of a deduction may be motivated by a desire to present an appropriately conservative picture of current profitability, the Act is motivated by a different purpose: the raising of public revenues. For these reasons, it is more appropriate in considering the s. 9(1) business test to speak of "well accepted principles of business (or accounting) practice" or "well accepted principles of commercial trading". [Emphasis in original.]
32 The great difficulty which seems to have plagued the courts in the assessment of profit for income tax purposes bespeaks the need for as much clarity as possible in formulating a legal test therefor. The starting proposition, of course, must be that the determination of profit under s. 9(1) is a question of law, not of fact. Its legal determinants are two in number: first, any express provision of the Income Tax Act which dictates some specific treatment to be given to particular types of expenditures or receipts, including the general limitation expressed in s. 18(1)(a), and second, established rules of law resulting from judicial interpretation over the years of these various provisions.
(emphasis added)
Subsection 9(2) of the Act specifically requires that the loss is to be computed by applying the provisions of the Act. The question is whether the deductibility of these expenses is to be denied as not being incurred for the purpose of gaining or producing income as required by the specific wording of paragraph 18(1)(a)? This places such a restrictive interpretation on that section to deny any taxpayer who is winding-up his business the right to ever claim what any reasonable commercially-minded business person would regard as legitimate business costs. As Associate Chief Judge Bowman indicated in Randhawa v. Canada, [2001] T.C.J. No. 308 where expenses similar to the expenses at issue here were incurred due to a tenant's neglect:
11. These expenses arose out of the rental operation that the appellant carried on. They were a direct and necessary incident of that operation and were expenses that have to be satisfied out of the circulating capital of the business.
In that case the Appellant did rent the premises, albeit briefly, after the expenses were incurred, but then personally moved into the property shortly thereafter.
[15] The Respondent's position is that as soon as the last tenant shuts a door behind him and consequently turns off the income stream, no expenses thereafter can be deductible. I do not accept however that the rental business has immediately ceased at that point. The evidence was that the Appellant continued to hound the tenant to make good on his commitment under the lease, to the point that the tenant actually did show up to assist in the cleaning. The rental business as such was not fully wound-up until the last of the damage issues with the former tenants had been resolved. This should occur within a reasonable time period given the nature of the business and clearly should involve only such costs as are reasonable in the circumstances. Mr. Raegele did deal with the repairs on a timely basis and did incur only reasonable expenses. The Raegeles did not take this as an opportunity to complete extensive upgrades, and where they believed there was some improvement they themselves deducted an appropriate amount for their claim. Even though Mrs. Raegele had no income against which to deduct expenses, Mr. Raegele did not try to claim all of the expenses himself. Indeed the Raegeles were the epitome of reasonable. I find the rental business continued until all the repairs were completed and bills paid. As such the expenses were incurred as part of the business and as Vern Krishna stated in The Fundamentals of Canadian Income Tax, 6th edition at page 278:
The essential limitation in paragraph 18(1)(a) is that the taxpayer must incur the outlay or expense "for the purpose" of gaining or producing income "from the business". Thus, the purpose must be that of gaining or producing income from the business in which the taxpayer engages. A fortiori, the business must exist at the time that the taxpayer incurs the expenditure.
[16] I refer to a recent case by Judge Hershfield, Mikhail v. Her Majesty the Queen, in which he indicated at paragraph [29]:
As to the application of paragraph 18(1)(a), I am inclined to say that it should not be so readily applied simply because the income producing asset is up for sale during an extended period of income deprivation particularly in cases such of this where the extended period of income deprivation is caused by extraordinary conditions beyond the control and expectation of the taxpayer. The asset was acquired and held as a rental property. It continued to be a rental property even when the income stream ended. One should not so readily dismiss an income earning purpose in respect of an expenditure when the characterization of the property has not changed. That is, provided the property has not been put to another use to which such expenditure might more appropriately attach, it remains a rental property and current expenses incurred, including expenses incurred while the property is not earning income, should not be so readily denied as not having been incurred for the purpose of earning income. While contrary to current thinking, I might go so far as to suggest that even if the income stream of an enterprise was at an absolute end, a reasonable sell-off period should be recognized during which holding expenses should be allowed. They are costs attaching to the income earning process which includes start-up costs as well as wind-up costs. That expenses during the last days of the life of an enterprise might relate to income earned in a prior year should not necessarily be fatal to their deductibility where they are costs that are a necessary part of the income producing activity albeit not incurred during the income producing years. Recognizing such expenses gives a truer picture of the profit or loss from a particular activity. Considering the purpose test in paragraph 18(1)(a) then, it should not be required that a purpose be only forward looking although that is how paragraph 18(1)(a) has always been applied. That paragraph does not, after all, say "for the purpose of gaining or producing income in the future".
[17] I wish to address Judge Hershfield's comments as to whether the expenses relate to the next use of the property being, in this case, the personal residence of the Raegeles. In effect, are the expenses personal or living expenses? Personal or living expenses are defined in section 248 as follows:
248 (1) In this Act,
"personal or living expenses" includes
(a) the expenses of properties maintained by any person for the use or benefit of the taxpayer or any person connected with the taxpayer by blood relationship, marriage or adoption, and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit,
[18] There are two conditions to be met to fall in this category: first, the property expenses were for the benefit of the taxpayer and second, they were not in connection with the business. It is easy to find that Mr. Raegele would personally benefit from these expenditures, as indeed he did take up residence in the property. However, as I have found that Mr. Raegele's business continued until the last of the repair expenses were incurred, I have no difficulty in finding that such expenses relate to a property maintained in connection with a business carried on for profit. I am not prepared to find that on July 15, 1998 Mr. Raegele's business went from a business carried on for profit to a not for profit business. It is simply a matter of a profitable business winding down. I find the expenses relate to the business, more so than to the next use of the property as the Raegeles' personal residence.
[19] I am drawn to Judge Hershfield's reasoning. I am also satisfied the expenses were incurred while there still existed a business, albeit in a wind-up phase. Does adopting this approach elevate the application of ordinary commercial principles to a status which effectively overrides a specific provision (paragraph 18(1)(a)) of the Act? I think not. The purpose required of paragraph 18(1)(a) in a wind-up situation, need not be to produce future income, but it is met where the cause of the expenses incurred is directly linked to the income producing activity of the business. Clearly such expenses must be reasonable and must be incurred prior to the final nail being hammered into the business' coffin.
[20] While the analysis thus far would suggest that there is sufficient reason to allow the Appellant's appeal, I find in this case there is a more direct answer to the "purpose" question posed by paragraph 18(1)(a). The Respondent argues that Mr. Raegele admitted his purpose in making the expenditures was so he could move in, which does not sound like a purpose of earning or producing income. However, neither Mr. Raegele nor his agent are lawyers versed in the complex nuances of legal phrases. Why did Mr. Raegele incur the expenses when indeed they were the tenant's responsibility? Had the tenant met his obligation under the lease to pay for such repairs and reimbursed Mr. Raegele for the cost of the damage, that payment to Mr. Raegele would have been in the nature of income. Would the expenses then still have been disallowed? Certainly not. The Appellant should not be denied the deduction because of a tenant defaulting on his indemnity. Mr. Raegele incurred the expenses with the knowledge and understanding that he had an income right related to the expenditure, being a right of indemnity.
[21] Mr. Raegele hounded the tenant to meet his contractual obligations and indeed had some success in obtaining payment for the water bill and some window cleaning. These amounts were not paid directly to Mr. Raegele but to the utilities company and the window cleaning company. Mr. Raegele determined however that potential lengthy and costly legal proceedings did not justify pursuing the tenants more aggressively than he had already. I am satisfied however that the fact he could have done so, provides to Mr. Raegele the necessary purpose required by paragraph 18(1)(a). The expenses were incurred to position Mr. Raegele to rely on the tenants' indemnity in the lease (a production of income). The effect of the expenses was to make the property habitable for Mr. Raegele and his family. I find that the requisite purpose of paragraph 18(1)(a) has been met.
[22] In summary, common sense and ordinary commercial and accounting principles support the Appellant's position that expenses incurred, during a wind-up phase of a rental property business, to repair damages caused by a former tenant, are legitimate deductible business expenses. They are not personal or living expenses. For the reasons given I do not believe this abuses the specific wording of paragraph 18(1)(a). However, in further addressing the application of paragraph 18(1)(a) specifically to these circumstances, I find the Appellant's purpose in making the expenditure was to produce income from the tenant through the tenant's obligation under the lease to indemnify the Appellant. Paragraph (18)(1)(a) does not restrict the deductibility of Mr. Raegele's expenses.
[23] For these reasons I allow the appeal and refer the matter back to the Minister of National Revenue for reassessment on the basis that the Appellant is entitled to deduct 50 percent of the repair expenses claimed by him in the amount of $16,373.68.
Signed at Ottawa, Canada, this 3rd day of April, 2002.
"Campbell J. Miller"
J.T.C.C.
COURT FILE NO.: 2001-3048(IT)I
STYLE OF CAUSE: Mark A. Raegele v. The Queen
PLACE OF HEARING: Ottawa, Canada
DATE OF HEARING: February 27, 2002
REASONS FOR JUDGMENT BY: The Honourable Judge Campbell J. Miller
DATE OF JUDGMENT: April 3, 2002
APPEARANCES:
Agent for the Appellant: B. Belchamber
Counsel for the Respondent: J. Michelle Farrell
COUNSEL OF RECORD:
For the Appellant:
Name:
Firm:
For the Respondent: Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada
SCHEDULE A
Mark Raegele
Taxation Year - 1998
STATEMENT OF MAINTENANCE & REPAIR EXPENSES
|
Date |
Description |
Amount |
|
08-Jun |
Parent Heating & Cooling Inc. |
$398.63 |
|
26-Jul |
House cleaning |
25.12 |
|
29-Jul |
Home Depot |
60.24 |
|
31-Jul |
Home Depot |
49.80 |
|
2-Aug |
Home Depot |
17.68 |
|
8-Aug |
Pierre Cantin Flooring |
5,003.32 |
|
10-Aug |
Discount Pro Cleaners |
128.40 |
|
12-Aug |
Assured Renovations Limited |
4,815.00 |
|
21-Aug |
Home Depot |
139.54 |
|
23-Aug |
Multi Flooring |
7,917.00 |
|
9-Sep |
Professional Driveway Sealing |
200.00 |
|
11-Sep |
Home Depot |
58.05 |
|
18-Sep |
Builder's Warehouse |
16.62 |
|
19-Sep |
Builder's Warehouse |
25.49 |
|
24-Sep |
Builder's Warehouse |
4.34 |
|
24-Sep |
Builder's Warehouse |
25.57 |
|
24-Sep |
Builder's Warehouse |
16.62 |
|
28-Sep |
Builder's Warehouse |
6.64 |
|
Total of receipts submitted |
18,908.06 |
|
Amount of maintenance & repairs claimed by App'l |
$16,373.68 |
|
Amount allowed incurred prior to July 15, 1998 |
(398.63) |
|
Difference |
15,975.05 |
|
Appellant's share (50%) |
$7,988.00 |
|
Rental loss as claimed by Appellant |
$(6,087.00) |
|
Add: disallowed expenses per above |
7,988.00 |
|
Revised net rental income |
$1,901.00 |
2001-3048(IT)I
BETWEEN:
MARK A. RAEGELE,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeal heard on February 27, 2002 at Ottawa, Canada, by
the Honourable Judge Campbell J. Miller
Appearances
Agent for the Appellant: B. Belchamber
Counsel for the Respondent: J. Michelle Farrell
JUDGMENT
The appeal from the reassessment made under the Income Tax Act for the 1998 taxation year is allowed, and the matter is referred to the Minister of National Revenue for reconsideration and reassessment in accordance with the attached Reasons for Judgment.
Signed at Ottawa, Canada, this 3rd day of April, 2002.
|
"Campbell J. Miller" |
J.T.C.C.
[1] Justice Iacobucci indicated in the Supreme Court of Canada appeal of this decision that Justice Stone indeed overstated the status of the matching principle.