Tax Court of Canada Judgments

Date: 20000919

Docket: 98-2386-IT-G

BETWEEN:

KLAUS SUDBRACK,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Bowman, A.C.J.

[1] These appeals are from assessments for the appellant's 1994 and 1995 taxation years.

[2] A number of issues are raised, as follows:

(a) Whether the Minister was justified in allowing the appellant only 85% of the interest expenses claimed by him in respect of money borrowed for the renovation of a house to be used as a country inn.

(b) Whether the Minister was justified in restricting the appellant's losses from the operation of the country inn on the basis that the entire inn was a self-contained domestic establishment within the meaning of subsection 18(12) and section 248 of the Income Tax Act and the business part of the property was a work space within that self-contained domestic establishment.

(c) Whether the Minister was justified in disallowing the appellant's claim for investment tax credits on the basis that the kitchen that was added to the inn was not qualified property for the purposes of subsection 127(9) of the Act because it was not a building or machinery and equipment to be used primarily for the purpose of manufacturing or processing of goods for sale or lease.

(d) Whether the appellant is entitled to capital cost allowance on the basis that his cost of renovating the house, including the addition of the kitchen, comprising the building (class 1) and the equipment (class 8) was as claimed $200,473.63 or $170,402.59 as computed by the Minister, on the basis that 85% of the use of the inn was for business purposes and 15% was personal, for the purposes of paragraph 13(7)(c) of the Act.

(e) Whether the losses claimed should be allocated to the appellant and his spouse Petra on a 50:50 basis, on the ground that the appellant and his spouse were partners.

[3] It is alleged in the notice of appeal that the appellant purchased a large older home in 1991 and moved it to the edge of Little Shemogue Harbour, New Brunswick. This allegation is denied. The house was acquired and moved as stated but title was held by the appellant's wife Petra. There is no suggestion that she held it in trust for the appellant.

[4] Although there was conflicting evidence on this point I find as a fact that the primary intention was to develop the property into a tourist facility, specifically a guest home (Gasthaus) or country house known as The Little Shemogue Country Inn which would serve meals and provide sleeping accommodation.

[5] Extensive renovations were made to the house. Five bedrooms with adjoining bathrooms were installed for guests. A new kitchen was added and three dining rooms. A private living area was installed for Mr. and Mrs. Sudbrack consisting of a bedroom, living area, bathroom and two bedrooms in an attic for their daughters. It is accepted that this area made up about 15% of the total area of the house.

[6] The construction of the kitchen, which was an addition to the house and which was about 17% of the entire area, cost $29,432. Mr. Sudbrack stated that of this amount over $20,000 related to equipment (class 8). On cross-examination however he admitted that a significantly greater portion was attributable to the construction of the building (class 1).

[7] I turn now to a consideration of each of the issues.

[8] The appellant borrowed $100,000 from the Bank of Montreal to do the renovations. 15% of the entire area was the private living area for Mr. and Mrs. Sudbrack. Counsel for the appellant argued that for safety and security reasons Mr. and Mrs. Sudbrack had to live on the premises. Moreover it was apparently a requirement of provincial law that they do so.

[9] I accept that Mr. and Mrs. Sudbrack lived at The Little Shemogue Country Inn as a matter of practical, economic and legal necessity. Does it follow from this finding that all of the cost of renovation, including the interest on borrowed money, is attributable to the business that was carried on? It frequently happens that a person may occupy a living space that is contiguous to the area where that person's business is carried on. A professional person for example, such as a doctor or lawyer, may practice his or her profession in a portion of their residence. In this case the necessity for living at the inn is considerably more compelling than in the case of the doctor or dentist who practices out of his or her home. Nonetheless, here we have a separate living area for the family and, whatever may have been the practical or legal considerations that compelled the Sudbracks to live at the inn, they had to live somewhere and I do not think that the Minister was unreasonable in allocating 15% of the interest expense to personal use. Subsection 4(1) of the Act requires a reasonable allocation of deductions to particular sources and an allocation based on the area of the personal living space strikes me as reasonable. This disposes of the factual issue.

[10] The legal issues raised by counsel for the appellant are a little more complex. Counsel points to the words in subparagraphs 20(1)(c)(i) and (ii):

(c) An amount paid in the year or payable in respect of the year ... pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property ...,

(ii) an amount payable for property acquired for the purpose of gaining or producing income from the property or for the purpose of gaining or producing income from a business ...

[11] From these words he argues that as a matter of law no allocation is permissible or, at all events, since the housing accommodation in the inn was inextricably bound up with the business, the entire amount of interest is deductible. I have dealt with the latter argument above.

[12] So far as the pure legal matter of statutory interpretation is concerned, the opening of section 20 contains the words

... or such part of the following amounts as may reasonably be regarded as applicable thereto.

[13] Counsel compares paragraph 20(1)(c) with paragraph 13(7)(c) and observes that the latter explicitly requires an apportionment between business and non-business use of depreciable property.

[14] The opening words of section 20 have, in my view, precisely the same purpose and effect with respect to interest expense.

[15] I have read the article by John R. Owen in the Canadian Tax Journal (2000, Volume 48, Issue Number 2), "Subparagraph 20(1)(c)(i): What Is Its Purpose?" With respect, I do not agree that that article supports the view that where borrowed money is used for both a business and non-business purposes, subparagraph 20(1)(c)(i) authorizes no apportionment between the two.

[16] The Minister restricted the appellant's losses under subsection 18(12). That provision reads:

Notwithstanding any other provision of this Act, in computing an individual's income from a business for a taxation year,

(a) no amount shall be deducted in respect of an otherwise deductible amount for any part (in this subsection referred to as the "work space") of a self-contained domestic establishment in which the individual resides, except to the extent that the work space is either

(i) the individual's principal place of business, or

(ii) used exclusively for the purpose of earning income from business and used on a regular and continuous basis for meeting clients, customers or patients of the individual in respect of the business;

(b) where the conditions set out in subparagraph (a)(i) or (ii) are met, the amount for the work space that is deductible in computing the individual's income for the year from the business shall not exceed the individual's income for the year from the business, computed without reference to the amount and sections 34.1 and 34.2; and

(c) any amount not deductible by reason only of paragraph (b) in computing the individual's income from the business for the immediately preceding taxation year shall be deemed to be an amount otherwise deductible that, subject to paragraphs (a) and (b), may be deducted for the year for the work space in respect of the business.

Subsection (b) was amended applicable to 1995. Prior to that it read:

(b) where the conditions set out in subparagraph (a)(i) or (ii) are met, the amount for the work space that is deductible in computing the individual's income from the business for a taxation year shall not exceed the individual's income from the business for the year, computed without reference to the amount.

[17] "Self-contained domestic establishment" is defined in section 248 as follows:

"self-contained domestic establishment" means a dwelling-house, apartment or other similar place of residence in which place a person as a general rule sleeps and eats.

The French version (établissement domestique autonome) is as follows:

“ établissement domestique autonome ” Habitation, appartement ou autre logement de ce genre dans lequel, en règle générale, une personne prend ses repas et couche.

[18] The first question is what is the self-contained domestic establishment: the living quarters of Mr. and Mrs. Sudbrack and their family or the inn as a whole?

[19] I think the better view, on the facts of this case, is that the separate living quarters of the family, which are essentially a separate apartment within the inn, constitute the self-contained domestic establishment. This appears to be the more reasonable approach and is, I believe, more consonant with what subsection 18(12) is seeking to achieve. Counsel for the Appellant referred to a decision of the Supreme Court of Canada in Bell v. Ontario (Human Rights Commission), [1971] S.C.R. 756. That case dealt with the meaning of "self-contained dwelling". It is not of much assistance in this case because here we are dealing with a statutory definition.

[20] The Crown's position is that the inn as a whole is the self-contained domestic establishment. Tab 17 of Exhibit R-1 contains a detailed summary of the adjustments made under subsection 18(12). It allocates between expenses not related to the work area and the expenses related to the work area. No challenge is made to the arithmetical calculation if the fundamental assumption that the self-contained domestic establishment is the inn as a whole and the "work space" in that self-contained domestic establishment is the inn as a whole as well is correct.

[21] In my view that basic assumption is wrong. The self-contained domestic establishment is the family apartment. Moreover, if the inn as a whole is the "work space" that work space is "the individual's principal place of business". Accordingly there is, in effect, excised from the area to which the limitation in paragraph (a) applies the 85% of the inn in which the family does not live.

[22] The work space within the "self-contained domestic establishment" (the family apartment) would consist of the kitchen which served the dual function as the family cooking space and the restaurant cooking space and the small room where Mr. Sudbrack kept his computer, records and other equipment for the purposes of the business.

[23] The result of this is that the disallowances for 1994 and 1995 under subsection 18(12) of $15,767.39 and $13,302.71[1] (which the respondent concedes may be carried forward to later years under subsection 18(12)) will need to be reduced. I do not propose to attempt this calculation, but the amounts disallowed would need to be reduced by at least 85%. If the parties cannot agree on the figures the amounts disallowed under subsection 18(12) will have to be reduced by 85%.

[24] The third issue is the matter of the ITCs. In 1994 the appellant claimed $4,414.77 as ITCs in respect of the cost of the addition of the kitchen and the equipment relating thereto.

[25] The question is whether the kitchen and the kitchen equipment are qualified property as defined in subsection 127(9) which reads in part as follows.

"qualified property" of a taxpayer means property (other than an approved project property or a certified property) that is

(a) a prescribed building to the extent that it is acquired by the taxpayer after June 23, 1975, or

(b) prescribed machinery and equipment acquired by the taxpayer after June 23, 1975,

that has not been used, or acquired for use or lease, for any purpose whatever before it was acquired by the taxpayer and that is

(c) to be used by the taxpayer in Canada primarily for the purpose of

(i) manufacturing or processing goods for sale or lease,

...

[26] Within that definition the only questions are:

(a) Whether the addition of the kitchen involves the construction of "a ... building ... to be used by the taxpayer in Canada primarily for the purpose of manufacturing or processing goods for sale or lease".

(b) Whether the kitchen equipment is "machinery and equipment to be used by the taxpayer in Canada primarily for the purpose of manufacturing or processing goods for sale or lease".

[27] It is, I believe, settled that preparation of food for immediate consumption is manufacturing or processing goods for sale — Burger King Restaurants of Canada Inc. v. R., [1997] 1 C.T.C. 2058; affirmed [2000] 2 C.T.C. 1.

[28] This does not however conclude the matter. The kitchen is not a separate building. It is part of the inn and it takes up about 17% of the space of the entire building. The Federal Court of Appeal has decided in Burger King Restaurants as well as Mother's Pizza Parlour (London) Ltd. et al. v. The Queen, [1988] 2 C.T.C. 197, that in determining whether a building is used primarily for a particular purpose one must compare the percentage of space devoted to that purpose with the area of the whole building. Since the kitchen space does not come near 50% of the area of the entire inn the claim for ITCs in respect of the structural part of the kitchen must be rejected.

[29] The kitchen equipment is another matter. I find as a fact that the cooking and refrigeration and other kitchen equipment meet the tests in subsection 127(9) and the cost of this equipment qualifies for the ITC. On reassessment the Minister can determine the portion of the cost attributable to the equipment.

[30] The appellant was allowed to claim capital cost allowance on only 85% of the cost of the inn and the moveable property on the same basis as the interest expense was reduced by 15%. The same reasoning applies to the claim for capital cost allowance under paragraph 13(7)(c).

[31] Finally, I come to the question whether the losses from the business should be divided between the appellant and his spouse, on the basis that they were partners. The conclusion that they were partners is not difficult. They obviously were. Mrs. Petra Sudbrack worked full time at the inn and devoted a large part of her time to preparing gourmet meals. The property was registered in her name and there is no suggestion that she held it in trust for her husband. I think the finding of fact that is most consonant with the evidence is that Mr. and Mrs. Sudbrack carried on the business of the inn as partners ("the relation that subsists between persons carrying on a business in common, with a view of profit") and that they held the inn as partnership property.

[32] The more difficult question is whether the Crown can raise the argument at this point, having assessed Mr. Sudbrack as a sole proprietor. Ever since M.N.R. v. Pillsbury Holdings Ltd., 64 DTC 5184, it has been assumed that the Crown could raise alternative bases for supporting an assessment even though they were not considered when the assessment was made. The onus, of course, lay upon the Minister to establish that alternative basis.

[33] Doubt was cast on this long-standing belief by the decision of Bastarache J. in The Queen v. Continental Bank of Canada, 98 DTC 6501 at 6504-5. In that case the Crown in the Supreme Court of Canada sought to advance a new argument in support of the assessment. Bastarache J. held that it could not do so. This is I think simply a restatement of the principle that new arguments cannot be raised at an appellate level that were not raised at trial. Simple procedural fairness requires that one party cannot raise at an appellate level an argument in respect of which the other party had no opportunity to call evidence at trial. Here the question of the partnership between the appellant and his wife was raised in the reply to the notice of appeal.

[34] I do not think that the Minister is precluded from raising the point. In this I am in respectful agreement with the reasoning of Bonner J. in Smith Kline Beecham Animal Health Inc. v. The Queen, 2000 DTC 1526. At page 1530 he said:

[14] In my view Continental Bank was never authority for the proposition that the Minister is, when defending an appeal from an assessment after the expiry of the subsection 152(4) period, confined within a conceptual prison called "basis of assessment" comprising only the facts and statutory provisions relied upon by the assessor. In my view Continental Bank is an application of the long-standing rule governing litigation in appellate courts which rule prevents litigants from raising points on appeal which were not pleaded and argued in the trial court. Appellate courts cannot be expected to deal with a new issue on appeal resting on an evidentiary record which is deficient by reason of the failure to plead and direct evidence to that issue. Here the Respondent seeks leave to amend well before the commencement of the trial. The situation is in no way analogous to Continental Bank.

[15] Furthermore, nothing said in Continental Bank suggests that subsection 152(4) has a bearing on the amendment which the Respondent seeks. Subsection 152(4) restricts the right of the Minister to "... reassess or make additional assessments, or assess tax, interest or penalties ...". The amendment now in question would not effect a reassessment of tax. Rather it is an attempt to defend the existing assessment of tax by asserting that, on the facts already pleaded, liability is imposed by a provision of the Act other than that relied on by the assessor.

[16] It is long-settled law that the validity of an assessment depends on the application of the statute to the facts and not on the assessor's analysis. It is, I believe, unlikely that it was the intention of the Court in Continental Bank (supra) to overrule decisions such as Minden (supra) and Riendeau (supra) without referring to them. Accordingly, I am of the opinion that nothing said in Continental Bank can apply to prevent the Minister from relying on section 245 in the present case.

[35] Judge Bonner's decision was affirmed by the Federal Court of Appeal on the basis of subsection 152(9), but without disapproving of his reasoning independently of subsection 152(9).

[36] Even if I were wrong in restricting the reasoning in Continental Bank to the ambit suggested by Bonner J., with whose reasons I agree, subsection 152(9) would permit the respondent to raise the partnership argument.

[37] I think that the losses should be divided between the appellant and Mrs. Sudbrack.

[38] The appeals are allowed and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with these reasons.

[39] Success is divided and accordingly I make no order for costs.

Signed at Ottawa, Canada, this 19th day of September 2000.

"D.G.H. Bowman"

A.C.J.

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