Tax Court of Canada Judgments

Date: 19980416

Docket: 97-3540-IT-I

BETWEEN:

CLIVE THOMSON,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Rip, J.T.C.C.

[1] Clive Thomson ("appellant") has appealed income tax assessments for 1992, 1993 and 1994 so that in computing his income for each year he be entitled to deduct expenses incurred in the operation of a "Bed and Breakfast" in Sydenham, Ontario, approximately 25 kilometres north of Kingston. The appellant says he is permitted to deduct their expenses in computing his income in accordance with paragraph 12(1)(a) of the Income Tax Act ("Act") since they were incurred for the purpose of earning income from a business or property. The Minister of National Revenue ("Minister") disallowed the expenses since they were personal or living expenses as defined by subsection 241(1) of the Act and therefore not deductible (paragraph 18(1)(h)).

[2] Mr. Thomson and his partner, David Beecroft, purchased a Victorian era four-bedroom house ("property") in 1985 for $130,000, of which they paid $30,000 or $40,000 in cash and the balance was paid by loan secured on a mortgage on the property. The appellant and his partner made extensive renovations to their property. The property was also the principal residence of the appellant and Mr. Beecroft.

[3] In 1986, the appellant and Mr. Beecroft began to rent out rooms and serve breakfast ("Bed and Breakfast") on the property under the name known as North Shore Bed and Breakfast ("North Shore").

[4] The property was on a lakefront and offered both summer and winter activities to guests of North Shore.

[5] The house, itself, was built in about 1862. The neighbouring area offered many recreational and tourist facilities and attractions.

[6] The area of the house was approximately 3,500 square feet; this included a screened area of about 500 square feet used as a sun room where breakfast was served during the summer. The house contained four bedrooms, two of which were available to guests. One guest-room had a double bed and the other guest-room had three beds. The appellant and his partner had complete use of all areas of the house, except for the use of guest-rooms when they were rented.

[7] When the appellant and Mr. Beecroft purchased the property, they intended to open a Bed and Breakfast and to retire to the property, said Mr. Thomson. Their "approximate idea", declared Mr. Thomson, was "aiming" to make it profitable. They attended a seminar in Kingston on how to advertise a Bed and Breakfast and consulted other Bed and Breakfast operations in the area. They also advertised extensively in leading magazines catering to people who would be attracted to the type of property owned by the appellant. Local newspapers featured articles on North Shore.

[8] Mr. Thomson stated that a typical profile of an owner of a Bed and Breakfast operation is one who owns the property and also has another occupation. In the case of the appellant, at all relevant times he was a professor of French at Queen's University; Mr. Beecroft was also employed.

[9] Two or three years after the North Shore commenced operation Messrs. Thomson and Beecroft realized that for a profit to be gained from the property the guest-rooms would have to be rented for at least 100 nights a year. During the first year of operation, the Bed and Breakfast generated approximately $1,500 in income; Mr. Thomson believes that perhaps the rooms were rented for 30 nights during that year. In 1993, he said, 200 couples rented the guest-rooms for approximately 100 nights; there were twelve guests between January and April and ten between October and December. He said his best year was 1989. Mr. Thomson "started off" in the 1980’s renting the room with three beds for $40 a night. In 1994 the North Shore charged $54 for the guest-room with the double bed and $57 for the room with three beds. In none of the years did the North Shore have a profit. Mr. Thomson believes no profit was earned since "a Bed and Breakfast business requires several years to show a profit ... to build up a clientele". He said at the beginning he and Mr. Beecroft realized they would require several years of operation before a profit would be made; he had no idea what the "several" years were.

[10] With respect to 1989, Mr. Thomson said North Shore was close to profitability but a recession took place and business in the Kingston area declined. He believed in 1989, when the revenue reached $7,000, that the next year would be profitable. However, tourism fell in 1990. Mr. Thomson said that since 1993 losses were declining. The losses from North Shore were:

Year Revenue (Loss)

1989 $8,400* ($ 9,854)

1990 $4,400^* ($15,996)

1991 $3,800^* ($14,104)

1992 $3,387 ($11,695)

1993 $5,978 ($ 5,511)

1994 $ 745 ($ 5,705)

[11] The North Shore was only operated for six months in 1994.

[12] The above losses are before any capital cost allowance was deducted. The bulk of the expenses was mortgage interest. For the years under appeal, 1992, 1993 and 1994, the amounts of interest paid on the mortgage on the property were $12,720, $8,458 and $5,190 respectively.

[13] Mr. Thomson said that he and Mr. Beecroft made efforts to reduce expenses. For example, they originally employed a student during the months of May to September but in later years they did not re-employ that person. Mr. Thomson also stated that he and Mr. Beecroft refinanced the property in 1993 to increase the mortgage to $145,000. However, they renewed the mortgage for periods of six months during the years of appeal so as to obtain lower interest rates. Mr. Thomson stated that improvements were also made to the property: a boat house was built for $15,000, a new bathroom was built for guests, a new furnace was installed, insulation was added, limestone on the building was cleaned, and all this required extra funds.

[14] When Mr. Thomson and his partner acquired the property in 1986, there were only two other Bed and Breakfast operations in the Kingston area. The number increased to six and was again reduced to two when the appellant and his partner sold the property in 1994 to permit Mr. Thomson to accept a position at University of Western Ontario in London. The North Shore was the only Bed and Breakfast open throughout the year.

[15] During the years in appeal, the appellant's income from Queen's University was:

Year Income

1992 $56,451

1993 $55,068

1994 $74,125

[16] In allocating expenses from the Bed and Breakfast operation, the appellant allocated 50% to personal use by him and his partner, and 50% was allocated to use by guests.

[17] Mr. Thomson testified that he and his partner tried to sell the property in 1990 with a view of finding a larger building for the Bed and Breakfast operation.

[18] Mr. Thomson realized it would be necessary to build up a winter business to increase the number of guests. He was in touch with the officials of nearby Frontenac Provincial Park to "aggressively" promote winter activity in that area. He contacted the manager of Frontenac Provincial Park to distribute brochures for North Shore. Mr. Thomson thought the property would be profitable with a year-round clientele. Crown counsel suggested that he would have had to average 23-room nights per month to show a profit in 1992. Mr. Thomson replied that he thought the summer and winter clientele would increase over the years. In 1992, rooms were rented to 35 guests for less than 100 room nights. There were almost 100 guests staying over 100 room nights in 1993 and revenue increased in that year, Mr. Thomson expected a further increase in 1994.

[19] Mr. Thomson testified that during the years 1986 to 1989, he and Mr. Beecroft also operated an art gallery on the property. The art gallery was not successful and was closed. This, Mr. Thomson suggested, demonstrated the seriousness in which North Shore was carried on.

[20] Mrs. Louise Tamblyn testified on behalf of the appellant. She has known Mr. Beecroft for 35 years and the appellant for the past 20 years. She and her daughters were visitors at North Shore in 1993 and on about two other occasions. They did not pay the appellant for lodgings during their stays.

[21] Mrs. Tamblyn was impressed with the operation of the North Shore and stated it was "a pleasure to stay" on the property. She indicated she had vacationed at Bed and Breakfasts in England, Scotland and other parts of Canada and was impressed by the professionalism of North Shore. There was a serious commitment by the owners, she declared.

[22] It is only when a taxpayer loses money from property and applies his or her losses to other income he or she earned or received in the year that the Minister questions the losses. The Minister queries whether the expenses of a property were maintained by the taxpayer for the use of the taxpayer and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit. If the property was not maintained in connection with a business carried on for profit or with a reasonable expectation of profit then the Act, at subsection 248(1), provides that the expenses of that property are personal or living expenses; personal or living expenses are not deductible by a tax payable in computing income: paragraph 18(1)(h).

[23] In 1977 the Supreme Court of Canada[1] considered what is necessary for a taxpayer to have a profit or reasonable expectation of profit so that expenses of a property would not be categorized a personal or living expense. Dickson, J. (as he then was) explained at page 5215:

Although originally disputed, it is now accepted that in order to have a "source of income" the taxpayer must have a profit or a reasonable expectation of profit. "source of income", thus, is an equivalent term to business: Dorfman v. M.N.R. [72 DTC 6131], [1972] C.T.C. 151. See also s. 139(1)(ae) of the Income Tax Act which includes as "personal and living expenses" and therefore not deductible for tax purposes, the expenses of properties maintained by the taxpayer for his own use and benefit, and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit. If the taxpayer in operating his farm is merely indulging in a hobby, with no reasonable expectation of profit, he is disentitled to claim any deduction at all in respect of expenses incurred.

[24] Mr. Justice Dickson went on to explain the meaning of the phrase "reasonable expectation of profit":

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer’s training, the taxpayer’s intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive. The factors will differ with the nature and extent of the undertaking: The Queen v. Matthews (1974), 28 DTC 6193. One would not expect a farmer who purchased a productive going operation to suffer the same start-up losses as the man who begins a tree farm on raw land.

[25] Recently the Federal Court of Appeal has considered anew in Tonn et al. v. M.N.R.[2], the relevancy of reasonable expectation of profit to the deductibility of losses. In A.G. of Canada v. Mastri et al.,[3] the Court held that where there is no personal element involved in the making of expenses "the judge should apply the reasonable expectation of profit test less assiduously than he or she might do if such a factor were present".[4] Robertson, J.A. writing for the Court, confirmed that Tonn cautioned against "second guessing" the business decisions of a taxpayer[5] whose commercial venture turns out to be less profitable than anticipated.[6]

[26] Soon after deciding Mastri, the Court of Appeal released its reasons in Watt v. The Queen.[7]Décary, J.A. writing for the Court, that a fair reading of Tonn and Mastri allows the following conclusion[8] when considering reasonable expectation of profit:

a) that a personal element may coexist with a profit motive; b) that where a personal element exists, it will prompt the Court to apply the reasonable expectation of profit test more assiduously; and c) that where the personal element is "the dominant, motivating force"[9] the taxpayer’s burden may be considerably more onerous.

[27] It is not my intention to second guess the business acumen of Mr. Thomson with respect to his decision to carry on the Bed and Breakfast venture. He and Mr. Beecroft never made any money from the venture; there were continuous losses. (I note that in computing the income of North Shore, no capital cost allowance was ever deducted.) The question before me is whether a reasonable person could have foreseen these losses in 1985, when Messrs. Thomson and Beecroft acquired the property.

[28] There is no evidence that before purchasing the property, either Mr. Thomson or Mr. Beecroft considered how much money they would have to earn from the North Shore so as to realize a profit. In other words, they appear not to have considered annual potential costs (for example, mortgage payments, repairs and maintenance, food, taxes, insurance, advertising, cleaning, hydro, heat, etc.) nor gross revenue. Other queries that seem to have been absent are the number of guests the North Shore would potentially attract in the year and the cost of improving the property. It was two or three years after they commenced the North Shore did the appellant and Mr. Beecroft begin to realize how many guests they would require to garner a profit. And even when, in 1993, they rented out the North Shore for over 100 nights - the number of nights they believed would make the North Shore profitable - the North Shore still had a loss.

[29] It is obvious, of course, that it is the rare business that has a profit in its first few years of operation. An optimistic, but realistic, owner who does not see a change in fortune within a reasonable time will close the business. Mr. Thomson, however, had no idea when a "turn around" would take place. "There comes a time in the life of any business operating at a deficit", wrote Decary, J.A., that “when the Minister must be able to determine objectively after giving someone a head start for a number of years, as the case may be, that a reasonable expectation of profit has turned to an impossible dream”.[10]

[30] Pictures of the property, newspaper articles and the testimony of Mr. Thomson and Mrs. Tamblyn all attest to the fact that the property was historic and attractive. Leisure activities were available for guests. The owners were attentive to the needs of guests. Mr. Thomson, if I understood his evidence, was of the view that owners of such high quality property must be carrying on a business with a reasonable expectation of profit by the very fact of operating such a high end property. This is not necessarily so: Messrs. Thomson and Beecroft had extra expenses due to the age of the property, for example.

[31] A personal element also existed. The owners lived on the premises and they had access to all of the property except when a guest-room was rented. Guest-rooms were made available to friends at no cost, at least when Mrs. Tamblyn and her daughters visited. The fact that the partners considered the property their principal residence creates the personal element as "the dominant, motivating force" in acquisition of the property. The lifestyle available to the appellant as an owner of the property was prime factor in deciding to operate North Shore.

[32] Messrs. Thomson and Beecroft expended untold energy and devotion to North Shore. They apparently built an excellent reputation in operating a Bed and Breakfast. But these are not in themselves sufficient to succeed in the appeals at bar.[11]

[33] The appeals are dismissed.

Signed at Ottawa, Canada this 16th day of April 1998.

“Gerald J. Rip”

J.T.C.C.

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