Date: 20020109
Docket: 2000-178-IT-G
BETWEEN:
KEVIN SHAUGHNESSY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasonsfor Judgment
Bowman, A.C.J.
[1] These appeals are from assessments for 1994 and 1995 by which the Minister denied losses sustained by the appellant from the rental of a condominium at Whistler, British Columbia. The allegation that the 1994 appeal was invalid was abandoned.
[2] The appellant, his brother Joseph Michael, William Oberton and William James Stuckey bought the condominium in December 1988 for $204,000. The property was mortgaged for $153,000 at an interest rate of 12% per annum. Each of the four had an undivided ¼ interest.
[3] The appellant testified that his object in buying the property was to have a long-term income producing property and not to sell it at a profit. This evidence is uncontradicted and is borne out by his subsequent purchase of the interests of the other participants. I accept his testimony.
[4] Counsel for the respondent spent some time cross-examining the appellant on two rental questionnaires in which he described his original purpose in buying the property "as an investment". I think counsel was trying to get the appellant to admit that by the word "investment" he meant that he bought it to sell at a profit and realize a capital gain, thereby leaving it open to the respondent to argue that since subsection 9(3) of the Income Tax Act provides that income does not include a capital gain the expenses were not laid out for the purpose of earning income within the meaning of paragraph 18(1)(a). Of course, it is open to question whether, if one buys property intending to sell it at a profit, it really is a capital property.
[5] I think three observations on this approach are warranted. In the first place I accept Mr. Shaughnessy's testimony with respect to his purpose in acquiring the property and increasing his investment.
[6] In the second place, the word "investment" is a completely neutral term. It can refer to a long-term investment in land and building or in corporate or government bonds — plainly a capital purpose — or it can refer to an investment in a commercial enterprise or in property that it is intended to sell at a profit (an adventure in the nature of trade). It could, depending on the context, refer to a purely non-commercial purpose, such as a new home.
[7] Third, even if counsel for the respondent had been successful in cross-examining the appellant into admitting that his real and predominant purpose was to sell the property at a profit, the enterprise would have been an adventure in the nature of trade and the expenses would have been deductible in any event (Roopchan v. The Queen, 96 DTC 1338).
[8] The matter was argued however on the basis of REOP and it is on that footing that I shall deal with it.
[9] The other participants may have had a different purpose from that of Mr. Shaughnessy. They became dissatisfied with the rate at which the property was appreciating in value and wanted out. In December 1993 the appellant bought out the interests of Oberton and Stuckey so that after that date the property was held as to ¼ by the appellant's bother Joseph Michael and as to ¾ by the appellant and his wife Shirley Anne Shaughnessy.
[10] In December 1996 the appellant's brother Joseph Michael sold his ¼ interest to the appellant and Shirley Anne Shaughnessy, so that the appellant and his wife each owned a 50% undivided interest. A new mortgage for $217,500 was taken out. In 1998 the appellant and his wife sold the property for $353,000.
[11] I shall quote paragraphs (f) to (o) of the so-called "assumptions" pleaded by the respondent:
(f) at all material times the Activity was undercapitalized;
(g) at all material times the appellant did not plan or make any material changes to the Activity;
(h) the Appellant has no training in the Activity;
(i) before starting the Activity, and in subsequent years, the Appellant did not prepare a business plan to determine if it would be profitable;
(j) the Appellant did not report any rental income or expenses in respect of the Property for the 1989, 1990, and 1991 taxation years;
(k) from 1992 to 1998 the Appellant reported the following losses from the Activity as real estate rental losses:
Taxation Gross Net
Year Income Expenses Loss
1992 3,007 9,471 6,464
1993 14,300 31,043 16,743
1994 11,025 29,063 18,038
1995 19,265 32,762 13,497
1996 17,021 31,648 14,627
1997 16,743 34,746 18,003
1998 16,065 32,885 16,820
Total $97,426 $201,618 $104,192
(l) the total amount of $161,104, which the Appellant deducted as rental expenses for the 1994, 1995, 1996, 1997 and 1998 taxation years, consists of various expenses which are set out in Schedule "A";
(m) the Appellant did not have a reasonable expectation of profit from the Activity during the 1994 and 1995 taxation years;
(n) the expenses claimed in relation to the Activity are not reasonable in the circumstances; and
(o) the expenses claimed in relation to the Activity were personal or living expenses of the Appellant and the other owners of the Property.
[12] Paragraphs (f), (g), (h) and (i) contain the usual boiler plate which is a familiar but essentially purposeless part of most REOP appeals. One pushes the appropriate button in the computer and it spews out paragraphs (f) to (i).
[13] Paragraphs (m), (n) and (o) contain more of the same sort of verbiage. Paragraph (m) is of course the mandatory ritual incantation of the mantra REOP. Paragraphs (n) and (o) are simply tossed in for good measure. They have no basis in the evidence and were not argued. They are so far-fetched that they could not possibly have been the basis of the assessments. I presume that pushing a button on the computer to produce paragraphs (n) and (o) requires approximately the same amount of reflection and deliberation as were required to produce paragraphs (f) to (i). The simple fact is that these identical paragraphs appear in replies in virtually every REOP case that comes before this court. It is unacceptable that this type of unthinking regurgitation of stereotypical verbal formulae should appear in all replies in REOP cases. The pleading of assumptions involves a serious obligation on the part of the Crown to set out honestly and fully the actual assumptions upon which the Minister acted in making the assessment, whether they support the assessment or not. Pleading that the Minister assumed facts that he could not have assumed is not a fulfilment of that obligation. The court and the appellant should be entitled to rely upon the accuracy and completeness of the assumptions pleaded. Sadly, this is becoming increasingly difficult. The entire system developed in our courts relating to assumptions and onus of proof is in jeopardy if the respondent does not set out the actual assumptions on which the assessment is based with complete candour, fairness and honesty.
[14] Although the appellant and his wife were co-owners of the property the appellant claimed all of the losses. It was not argued or pleaded that if the losses were deductible only 50% were deductible by the appellant. Therefore the appellant had no case to meet on the point. If he had he might have been able to justify his claim of the entire amount on the basis of the attribution rules in section 74.1 of the Income Tax Act. I am therefore dealing with the case on the basis that if the losses are deductible they are fully deductible by the appellant.
[15] In Donyina v. R., [2001] 3 C.T.C. 2741, I summarized what appeared to be the principles that has been established up to that point in the field of REOP. The appeals from the decisions of the Federal Court of Appeal in Stewart v. R., [2000] 2 C.T.C. 244, and Walls v. R., [2000] 1 C.T.C. 324, have recently been heard in the Supreme Court of Canada and we can expect that some fresh light will be shed on this somewhat murky area.
[16] The summary in Donyina was as follows.
[8] The REOP principle has been evolving. For a period of time after the Moldowan case assessors were zealously disallowing losses, that with the benefit of hindsight, they thought resulted from an activity with no REOP. Their fervour has been tempered substantially by such cases as Tonn et al. v. The Queen, 96 DTC 6001; A.G. of Canada v. Mastri et al., 97 DTC 5420; Mohammad v. The Queen, 97 DTC 5503; Kuhlmann et al. v. The Queen, 98 DTC 6652; Walls v. The Queen, 2000 DTC 6025 (under appeal to S.C.C.); Milewski v. The Queen, 99 DTC 968 (aff'd 2000 DTC 6559, F.C.A.); Kaye v. The Queen, 98 DTC 1659; Costello v. The Queen, 98 DTC 1362; Smith v. The Queen, 96 DTC 1886; Saunders v. R., [1998] 2 C.T.C. 3196, and Roopchan v. The Queen, 96 DTC 1338, as well as some earlier decisions of this court: Bélec v. The Queen, 95 DTC 121; Nichol v. The Queen, 93 DTC 1216, and N. Cipollone v. Canada, [1995] 1 C.T.C. 2598. The most recent pronouncement on this point is Keeping v. The Queen, 2001 F.C.A. 182.
[9] I shall not quote from these cases or analyse them at length. It is, I think, sufficient to summarize some of the principles that they appear to establish.
1. Where there is no personal element the REOP test should be applied sparingly (Tonn, Keeping, Bélec and Walls). The absence of a personal element does not establish conclusively that the REOP principle cannot be invoked but such an absence is a factor that carries a great deal of weight (Mastri).
2. The Minister or the court should not, with the benefit of hindsight, second-guess the business acumen of a taxpayer who embarks upon a business venture in good faith (Keeping, Tonn, Nichol, Kuhlmann, Bélec and Smith).
3. The fact that a business or property is 100% financed is not in itself a reason for applying the REOP principle (Milewski, Mohammad and Saunders).
4. A taxpayer should be allowed a reasonable period of time to get the business established (Keeping). Such a period will vary with the circumstances and may well be lengthy (Milewski).
5. The REOP principle should not be invoked as a substitute for analysis. Before invoking REOP the assessor should examine the expenses to determine whether they are reasonable or for any other reason not deductible (Smith, Costello and Cipollone).
6. For an expectation of profit to be reasonable it has to be not "irrational, absurd and ridiculous" (Kuhlmann).
7. The fact that an investment or a business is motivated in part by tax considerations is not relevant in determining whether there is a business, nor is tax motivation in itself relevant in determining the deductibility of expenses if a business exists (Stubart Investments Limited v. The Queen, 84 DTC 6305) unless of course the Minister chooses to invoke the general anti-avoidance rule in section 245, in which case we are into a fundamentally different ball-game.
8. The initial question where losses are claimed and denied is whether they are personal or living expenses, the statutory definition of which includes the REOP test. If they are not, the REOP test must be applied with extreme care and the question becomes "Is there a business?" The existence of REOP is only one factor in that determination (Kaye).
9. Reasonableness operates both in the context of the existence of a business, where section 67 disallows the deduction of expenses to the extent that they are unreasonable, and also at the liminal stage of determining whether there is a business (Kaye).
10. If what is ostensibly a rental property was acquired and held in the course of an adventure in the nature of trade and it was reasonable to expect a profit on the resale the losses (i.e. carrying costs net of rentals received) should not be disallowed on the basis of REOP (Roopchan). The court should however examine with some care an ex post facto declaration that property that was carried for some years at a loss is part of a speculative venture in which the motive was resale at a profit. This is not something that one would expect someone readily to admit if the property were sold at a profit.
11. If the taxpayer has several rental properties, some yielding a profit and some a loss, it is improper to apply REOP to the losing properties and ignore the profitable ones. The entire investment picture should be considered (Smith).
12. When to start a business and when to abandon it are business decisions in which neither the taxing authorities nor the court should intervene (Nichol). Nonetheless if losses go on being incurred year after year for an inordinate length of time sooner or later one has to apply what I shall call the "Enough is enough" principle and decide that what might have been a viable business has, with the effluxion of time, became hopeless and the best thing to do with it is to give it a decent burial. Nonetheless, a businessman's judgement to maintain a business must be treated with great respect.
[17] Applying each of these points to this case, the following conclusions are warranted:
1. There was no personal element. The appellant and his wife visited the property two or three days per year for cleaning and maintenance. Their friends and family did not use it.
2. Second-guessing the appellant's business judgement is precisely what the Minister is doing here. The appellant saw Whistler as a recreational area that was likely to expand and develop and their decision was based on rational research and enquiry.
3. The property was not fully financed. The appellant put a substantial amount of his own money into it from RRSPs that he cashed in. Even if it had been fully financed this would not have been fatal.
4. The appellant acquired most of his interest in the property in 1993 and in 1996 when he bought out the other participants. The Minister pounced on the 1994 and 1995 taxation years, immediately after the appellant had increased his interest in the property. Had he not decided to sell the property as a result of the assessing action of the CCRA he would have realized a profit in subsequent years. The Minister in my view was altogether too quick on the draw.
5. I have seen no evidence of any analysis — merely the usual chanting of REOP.
6. There is certainly nothing irrational, absurd and ridiculous about expecting a profit from renting property in one of the hottest recreational properties in North America.
7. There were no tax considerations in this investment.
8. These expenses are certainly not personal or living expenses.
9. There is no element of unreasonableness in the expenses. The point was pleaded in the reply and then dropped.
10. The property was not bought to resell.
11. This point is inapplicable.
12. The appellant over a ten-year period acquired an increasingly larger interest in the property and sold it in 1998. It is his decision and he cannot be faulted for it.
[18] Not one of these principles was observed by the CCRA in this case.
[19] There is one further nail that has recently been hammered into the REOP coffin: Ludco Enterprises Ltd. et al. v. The Queen, 2001 DTC 5505. In virtually all of the REOP cases I have heard the real killer has been the interest. Were it not for the interest usually the loss would be eliminated or substantially reduced. In 1994 and 1995 in this case the interest paid was $14,599 and $17,436 respectively. The losses reported were $18,038 and $13,497. The appellant stated that the gross income for those two years was incorrectly reported and should have been $18,000 and $22,000 respectively rather than $11,025 and $19,265. Using the revised figures for gross income, the loss for 1994 would have been $11,063 and for 1995 $10,762. The elimination of the interest charge would have erased the loss and created a profit.
[20] The denial of the losses is tantamount to a denial of the deduction of the interest expense. This I believe is demonstrably contrary to the decision in Ludco, where the interest expense was allowed on the basis that the borrowed money was used to acquire shares that produced dividend income. The following discussion by Iacobucci J., speaking for the unanimous court, is illuminating:
[58] In the case at bar, both the Tax Court of Canada and the Federal Court - Trial Division ostensibly applied this Court's decision in Moldowan v. The Queen, [1978] 1 S.C.R. 480, in equating "income" with "profit". However, that case was concerned not with the meaning of the term "income" as such, but with identifying the source of income in play and, more specifically, with differentiating between business activities as distinct from personal or hobby activities. It is clear that Moldowan,supra, does not stand for the absolute proposition that "income" necessarily means "profit".
[59 ] Because it is left undefined in the Act, this Court must apply the principles of statutory interpretation to discern what is meant by "income" in the context of s. 20(1)(c)(i). The plain meaning of s. 20(1)(c)(i) does not support an interpretation of "income" as the equivalent of "profit" or "net income". Nowhere in the language of the provision is a quantitative test suggested. Nor is there any support in the text of the Act for an interpretation of "income" that involves a judicial assessment of sufficiency of income. Such an approach would be too subjective and certainty is to be preferred in the area of tax law. Therefore, absent a sham or window dressing or similar vitiating circumstances, courts should not be concerned with the sufficiency of the income expected or received.
[60] As noted by Létourneau J.A., Bowman J.T.C.C. (as he then was) lucidly dealt with the argument that the word "income" in s. 20(1)(c)(i) necessarily means "profit" in Mark Resources Inc. v. The Queen, 93 D.T.C. 1004, at p. 1015. Most importantly, Bowman J.T.C.C. dismissed that argument at p. 1015 in these terms:
Interest on money that is borrowed to invest in common shares, or property, or a business or corporation is deductible because it is laid out to earn amounts that must be included in the computation of income. Amounts of income such as dividends which must be included in income under paragraphs 12(1)(j) and (k) do not cease to be income merely because they are exceeded by the cost of their production.
[61] I agree. Indeed, when one looks at the immediate context in which the term "income" appears in s. 20(1)(c)(i), it is significant that within the provision itself the concept of "income" is used in contradistinction from the concept of tax-exempt income. Viewed in this context, the term "income" in s. 20(1)(c)(i) does not refer to net income, but to income subject to tax. In this light, it is clear that "income" in s. 20(1)(c)(i) refers to income generally, that is an amount that would come into income for taxation purposes, not just net income.
[62] I am bolstered in this conclusion by the other evidence of Parliamentary intention. If Parliament had intended interest to be deductible only in circumstances where borrowed money was used for the purpose of earning "net income", it could have expressly said so. Indeed, as noted by Létourneau J.A., in both 1981 and 1991, amendments to the Act that would have restricted interest deductibility to circumstances where borrowed money is used for the purpose of making a profit were proposed but never enacted.
[21] The losses here were disallowed on the basis of the Minister's ceremonial chanting of the rubric identified by the acronym REOP, a gloss on the statute that, as applied by the CCRA as a free-standing test, cannot withstand rational scrutiny. Any realistic analysis of what the CCRA was doing in this case makes it crystal-clear that it was in essence disallowing the interest because it did not result in the production of net income. This is precisely the approach rejected by the Supreme Court of Canada in Ludco.
[22] The appeals are allowed with costs and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment to allow the deduction of losses in 1994 of $11,063 and in 1995 of $10,762. These are the losses resulting from the appellant's revision of his gross rental income in those years.
Signed at Toronto, Canada, this 9th day of January 2002.
"D.G.H. Bowman"
A.C.J.
COURT FILE NO.: 2000-178(IT)G
STYLE OF CAUSE: Between Kevin Shaughnessy and
Her Majesty The Queen
PLACE OF HEARING: Vancouver, British Columbia
DATE OF HEARING: December 13, 2001
REASONS FOR JUDGMENT BY: The Honourable D.G.H. Bowman
Associate Chief Judge
DATE OF JUDGMENT: January 9, 2002
APPEARANCES:
Counsel for the Appellant: F. Timothy Williamson, Esq.
Counsel for the Respondent: Carl Januszczak, Esq.
COUNSEL OF RECORD:
For the Appellant:
Name: F. Timothy Williamson, Esq.
Firm: Vancouver, British Columbia
For the Respondent: Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada
2000-178(IT)G
BETWEEN:
KEVIN SHAUGHNESSY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Appeals heard on December 13, 2001, at Vancouver, British Columbia, by
The Honourable D.G.H. Bowman
Associate Chief Judge
Appearances
Counsel for the Appellant: F. Timothy Williamson, Esq.
Counsel for the Respondent: Carl Januszczak, Esq.
JUDGMENT
It is ordered that the appeals from assessments made under the Income Tax Act for the 1994 and 1995 taxation years be allowed with costs and the assessments be referred back to the Minister of National Revenue for reconsideration and reassessment to allow the deduction of losses in 1994 of $11,063 and in 1995 of $10,762.
Signed at Toronto, Canada, this 9th day of January 2002.
|
"D.G.H. Bowman" |
A.C.J.