Date: 19990226
Docket: 97-2417-IT-G
BETWEEN:
JEAN-PAUL AUDET,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for judgment
(Delivered orally at Québec, Quebec, on February 4, 1999)
P.R. Dussault, J.T.C.C.
[1] Gentlemen, I see no point in postponing judgment in this case. The evidence that was adduced is very fresh in my mind. I have reviewed the documents that seemed to me to be the most relevant in the voluminous books you submitted to me.
[2] The appeals are from assessments for the appellant’s 1992 and 1993 taxation years. In those assessments, the Minister of National Revenue (“the Minister”) disallowed the appellant’s deduction, in computing his income, of rental losses on a condominium in the township of Magog.
[3] To begin with, as I said earlier, I do not believe the Federal Court of Appeal’s decision in Labrèche v. Her Majesty the Queen (December 15, 1998, file No. A-429-95) has any impact whatsoever on the instant case given the changes to operations in that case, the change of business premises, etc. I think that in the case at bar it has been clearly established that nothing has been changed since the appellant became involved by purchasing his condominium at Club Azur in 1988. I am using that name, as you did, to refer generally to the project at whatever point in time we are considering.
[4] Second, I would like to emphasize that the document given to me this morning by counsel for the appellant (Exhibit A-6) is one that, according to my notes, Mr. Parent referred to in his testimony. I would point out that that document differs in a few respects from a document found at Tab 1 of Exhibit A-1.
[. . . Discussion . . .]
[5] So as I told you, my general belief is that this case must be analyzed on the basis of four major decisions. First, there is the Supreme Court of Canada’s decision in Moldowan v. The Queen, [1978] 1 S.C.R. 480, 77 DTC 5213, in which it was stated at page 485 that in order to have a source of income a taxpayer must have a profit or a reasonable expectation of profit. However, it was also stated in that case—and this is an important point—that the matter of whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts.
[6] As we know, that principle was reiterated by the Federal Court of Appeal in Tonn v. Canada, [1996] 2 F.C. 73, 96 DTC 6001. The decision in that case was, it seems, misunderstood by a number of judges, so that in Mastri v. Canada, [1998] 1 F.C. 66, 97 DTC 5420, the Federal Court of Appeal felt that it had to set the record straight, if I may put it that way.
[7] In Mastri, supra, it was stated at page 74 that if as a matter of fact a taxpayer does not have a reasonable expectation of profit, then there is no source of income and therefore no basis upon which the taxpayer is able to calculate a rental loss.
[8] In Tonn, supra, there was a discussion of the personal elements to be used to distinguish different types of cases. It was stated that judges must take care not to substitute their judgment for the taxpayer’s when it comes to business decisions, especially in cases that involve no personal element or foreseeable tax benefit.
[9] Of course, when dealing with rental losses on immovable property, particularly condominiums and even more particularly resort condominiums, the personal element may be analyzed in terms of direct personal benefit. What immediately comes to mind here is the question of personal occupancy. It is true that there is no such element at all in the instant case.
[10] However, there are two elements that must be taken into account: the personal benefit and the foreseeable tax benefit. I believe that, given the taxpayer’s experience, of which he spoke in his testimony, it is clearly established in this case that the taxpayer knew the effect of the tax losses he was seeking to deduct from his professional income. It was not the first time he had made this type of investment: he had purchased condominiums in the Montréal and Québec areas that had generated no income but only rental losses. In 1998, the condominium in Québec was resold producing a profit or gain.
[11] Thus, in situations where neither strictly personal elements nor tax benefits are present, care must be taken not to engage in second-guessing. However, if one of these elements is present, I think that the situation must be examined much more closely.
[12] It was in Mohammed v. The Queen, [1998] 1 F.C. 165, 97 DTC 5503, at pages 173-75, that Robertson J.A. of the Federal Court of Appeal finally set out in some detail the problem posed by this type of situation involving rental losses.
[13] I refer to page 173, where Robertson J.A. provides the following analysis of just such a situation:
[7] Frequently, taxpayers acquire a residential property for rental purposes by financing the entire purchase price. Typically, the taxpayer is engaged in unrelated full-time employment.[1] Too frequently, the amount of yearly interest payable on the loan greatly exceeds the rental income that might reasonably have been earned. This is true irrespective of any unanticipated downturn in the rental market or the occurrence of other events impacting negatively on the profitability of the rental venture, e.g. maintenance and non-capital repairs. In many cases, the interest component is so large that a rental loss arises even before other permissible rental expenses are factored into the profit and loss statement. The facts are such that one does not have to possess the experience of a real estate market analyst to grasp the reality that a profit cannot be realized until such time as the interest expense is reduced by paying down the principal amount of the indebtedness. Bluntly stated, these are cases where the taxpayer is unable, prima facie, to satisfy the reasonable expectation doctrine. These are not cases where the Tax Court is being asked to second-guess the business acumen of a taxpayer whose commercial or investment venture turns out to be less profitable than anticipated. Rather these are cases where, from the outset, taxpayers are aware that they are going to realize a loss and that they will have to rely on other income sources to meet their debt obligations relating to the rental property.
[14] He continued as follows:
[8] The facts of this case illustrate the debilitating effect of high-ratio financing on the profitability of a rental venture. For the 1989 taxation year, the taxpayer’s share of gross rental income was $9,075. While his share of the expenses amounted to $16,320, the interest component equalled $13,212. In 1990, matters worsened with rental income declining to $8,552 and expenses climbing to $18,182, of which $15,826 was attributed to interest payments. During the taxation years in question, the property was rented and at the market rate. This is not a case where revenues fell below expectations. This is a case where the taxpayer could not reasonably expect to generate a profit until such time as the principal amount of the outstanding purchase-money indebtedness was reduced accordingly.
[15] In the next paragraph Robertson J.A. stated:
[9] Lack of immediate profit does not appear to dissuade taxpayers from engaging in the rental market for at least two reasons. First, the anticipated gain on the ultimate disposition of the property may be perceived to overtake any losses stemming from the payment of interest and, more so, if the profit is taxed as a capital gain. (See discussion infra as to the deductibility of interest under paragraph 20(1)(c) of the Act where property is purchased for the purpose of realizing a capital gain.) Second, the impact of the interest expense can be diminished if the rental loss can be deducted from other sources of income, typically employment income, pursuant to paragraph 3(d) of the Act. These tax realities help explain why individual taxpayers avoid the corporate structure as a means of holding ownership in rental properties. It is trite tax law that losses cannot be transferred from one taxpayer to another, except through the most sophisticated of tax planning schemes . . . .
[16] Omitting the rest of that paragraph, I move on to the next one:
[10] Putting aside the above motivational considerations, it is apparent that this group of taxpayers can have no reasonable expectation of profit provided that the interest component of the rental expenses exceeds anticipated gross rental income. Thus, so long as no payments are made against the principal amount of the purchase-money loans, there can be no reasonable expectation of profit.
[17] I find the text to be limpid and I cite it further:
If, however, the interest component of the rental expenses can somehow be reduced then a positive finding of profitability is easier to sustain, which finding will permit the taxpayer to deduct a portion of the rental loss from employment income. One way of achieving that end is to invoke section 67 of the Act. . . .
[18] The next paragraph reads as follows:
[11] The above analysis is to the effect that there can be no reasonable expectation of profit so long as no significant payments are made against the principal amount of the indebtedness. This inevitably leads to the question of whether a rental loss can be claimed even though no such payment(s) were made in the taxation years under review. I say yes, but not without qualification. The taxpayer must establish to the satisfaction of the Tax Court that he or she had a realistic plan to reduce the principal amount of the borrowed monies. As every homeowner soon learns, virtually all of the monthly mortgage payment goes toward the payment of interest during the first five years of a twenty to twenty-five year amortized mortgage loan. It is simply unrealistic to expect the Canadian tax system to subsidize the acquisition of rental properties for indefinite periods. Taxpayers intent on financing the purchase of a rental property to the extent that there can be no profit, notwithstanding full realization of anticipated rental revenue, should not expect favourable tax treatment in the absence of convincing objective evidence of their intention and financial ability to pay down a meaningful portion of the purchase-money indebtedness within a few years of the property’s acquisition. If because of the level of financing a property is unable to generate sufficient profits which can be applied against the outstanding indebtedness, then the taxpayer must look to other sources of income in order to do so. If a taxpayer’s other sources of income, e.g. employment income, are insufficient to permit him or her to pay down purchase-money obligations then the taxpayer may well have to bear the full cost of the rental loss. Certainly, vague expectations that an infusion of cash was expected from Aunt Beatrice or Uncle Bernie will not satisfy the taxpayer’s burden of proof. In practice, the taxpayer will discharge that burden by showing that significant payments were in fact made against the principal indebtedness in the taxation years closely following the year of purchase.
[19] To continue, the next paragraph states:
[12] The significance of the taxpayer being able to reduce interest costs by reducing the principal amount of the purchase-money indebtedness and doing so within a reasonable period has not gone unnoticed. It was alluded to in Tonn,supra. Early on in its reasons for judgment, the Court refers to the fact that the taxpayer in that case had paid down the mortgage loan in one of the taxation years in question, a fact that had not been adduced before the Tax Court and which the Minister argued was inadmissible on the application for judicial review . . . . In the present case, the taxpayer makes reference in his application record to such payments having been made. That evidence, however, does not appear to have been put before the Tax Court Judge and, in any event, was not raised during the hearing of this application for judicial review because of the limited issue being considered: see . . . application record . . . .
[20] I think I have cited the passages that I feel set out basically what must be found by a Tax Court of Canada judge in order to reach the conclusion that a taxpayer has a reasonable expectation of profit in given circumstances or a given situation.
[21] Turning now to the case at bar, I note that the taxpayer has some experience with this type of investment, since, as I said, he has made more than one such investment, initially in the Montréal area, where he bought a condominium on Nuns’ Island, and then in the Québec area, where he also bought a condominium. He has also made a number of real estate investments in Western Canada. I note as well that the taxpayer has admitted claiming rental losses year after year. It does not appear that either of the two investments in the Montréal and Québec areas, or any of his other investments for that matter, generated any rental income. There was only a gain in 1998 when the condominium in Québec was resold. This is one of the factors that must be taken into account.
[22] I should also note that the taxpayer was aware of the impact that claiming rental losses would have on his income tax through the reduction of his professional income. Here, the taxpayer read the rental and yield forecasts, which I would characterize as extremely optimistic. The appellant admits moreover that the forecasts were optimistic. He is aware, however, and has admitted that he could not make a profit because of the carrying charges, especially the high interest expenses. Yet he says that, even if the forecasts were reduced by half, this investment would compare favourably with his previous investments in condominiums.
[23] The appellant got involved in the project by financing 100 percent of the amount he needed, which in my view made it absolutely impossible for him to have any reasonable expectation of profit for an indefinite number of years.
[24] I pause here to look at the relevant figures and to refer to the initial forecasts. I am looking at the document submitted to me by the appellant himself, Exhibit A-1, Tab 1, at the pages marked 12 at the top and 17 at the bottom and 13 at the top and 18 at the bottom. They contain the initial forecasts made on the basis of the developer’s data by the firm of Samson Bélair, which prepared the various documents. These documents show that the anticipated occupancy rate from 1988 to 1997 went from 42 to 56 percent. Thus, over a period of ten years, we start at 42 percent in 1988 and climb to 56 percent in 1997. Forty-two percent is close to the percentage given in the evidence and referred to by Mr. Audet himself as being the occupancy rate in the area for comparable or similar places. So an occupancy rate of 42 to 56 percent was forecast. In response to certain questions asked on cross-examination, Mr. Audet himself said that an occupancy rate of 38 percent was needed to cover the overhead costs and that 65 to 68 percent was needed to pay the overhead costs and the mortgage interest. When asked what occupancy rate was necessary for him to be able also to pay the interest on the personal loan he had taken out, he answered that he did not know but that it would have had to be much higher.
[25] We can thus see from the outset that with such a financing structure, even if everything had gone as planned and the occupancy rates forecast in the documents had been attained, an occupancy rate much higher than those forecast would have been needed to pay the overhead costs, the mortgage interest and the interest on the personal loan. It is therefore by looking at these figures and putting things into perspective in the light of the comments of Robertson J.A. in Mohammad, supra, that I come to the conclusion that with such figures, even if everything had “gone like clockwork”, it was absolutely impossible to achieve profitability.
[26] The appellant himself admitted that the interest expenses were very high. There were two loans and 100 percent financing. Thus, considering the forecasts, which the appellant himself found optimistic and would even have reduced by half for the purpose of determining the investment’s profitability, it can be seen that an occupancy rate at least three times higher than what was forecast would have been needed in order to cover expenses. This was a mathematical impossibility.
[27] Moreover, as regards income, difficulties were experienced by successive administrations and there was no rental of units or very little. There were also, of course, some management problems. According to the contract, the initial approach involved running the project as a condominium hotel or tourist village, with management being handled centrally. This means that each owner in this type of condominium hotel or tourist village situation does not just start renting out his or her own condominium for a day or two or a weekend. The plan was for the entire project to be managed centrally.
[28] The difficulties did not take long to arise. The appellant’s contract was signed at the end of 1988. In 1989, there were already problems, and by the middle of 1989, there were very serious ones. In the summer of 1989, thought was being given to restructuring, which occurred at the end of 1989 and the beginning of 1990. In spite of this, the appellant did not change his approach in any way during the restructuring in 1989 or 1990, or even in 1992 when other problems arose and he should have been even more aware than at the outset that he could not make a profit.
[29] It was not just because there was no rental of units that there were no profits; the absence of profits was attributable to a much greater degree to the fact that the initial problem was still present, namely over-financing that made profitability impossible even on the most optimistic of assumptions.
[30] It was not until 1995 that the idea of substantially reducing the debt in relation to the initial schedule was had. The evidence is very clear on this. Strangely enough, however, it was at about the same time that Revenue Canada became involved. The same is true of the idea of long-term rental, which the appellant did not consider until the fall of 1995. Yet it can be seen that the possibility of withdrawing from the joint venture, taking charge of his own investment and renting out his condominium on a long-term basis, that is, for at least six months or a year, had existed since 1989. I noted this earlier. In this regard, one may refer to Exhibit I-1, Tab 45.
[31] What I also find from the evidence is that the appellant never personally reviewed the matter during all of those years and never sought advice from a source that was independent of the central administration. Thus, no advice was sought. Yet the losses were extremely high and the appellant was also being asked to invest additional money. No one was approached, there was no plan, things were neglected and the renting of the condominium was still being left to the central administration. In fact, the appellant stated that he did not even know whether the condominium had been rented during the two years at issue, 1992 and 1993. He made no effort to ensure profitability himself by taking charge of renting his condominium. Why? It is true that distance was a factor, but it must be acknowledged that other people had handled their own affairs and personally taken charge of renting their condominiums.
[32] One thing is clear: the tax benefit was still present and obviously influenced the decision to continue in the same way. The prospect of a long-term capital gain probably also influenced the appellant’s decision to keep the condominium. This is a classic situation as described in the passages of Mohammad, supra, to which I have referred.
[33] Thus, based on the evidence, it must be concluded that things did not change in fact or even in the appellant’s mind until 1995. It was then that certain specific events occurred. Revenue Canada got involved in the matter, of course. Yet in June 1995, the appellant, in response to the famous question 16 on the questionnaire submitted by Revenue Canada (see Exhibit I-1, Tab 51), did not see or anticipate any possibilities or courses of action other than selling, or rather the sale of the entire project. So again, the appellant did not have a profitability plan as regards his own condominium. However, some action began to be taken after that: first, the personal loan was repaid; then, the appellant went to Magog and met with Mr. Turbide; and, finally, he gave Mr. Turbide a mandate to rent the condominium out on a long-term basis rather than letting the central administration try to rent it out by the day. Mr. Turbide was able to rent the condominium initially for three months and then for six months and subsequently for a year, and there is now a two-year lease on it. However, none of this occurred until 1995.
[34] If I had had to decide the case as well for all the years following the years at issue, my decision might perhaps have been different or I might have had a different viewpoint in analyzing the case. However, I must focus my analysis on 1992 and 1993 and apply it to those years. Based on the foregoing, I am of the opinion that during those years the appellant did not have a reasonable expectation of profit in respect of the condominium he purchased in the Magog area in 1988. I cannot reach any other conclusion given the tests laid down in the case law.
[35] I must therefore dismiss the appeals for 1992 and 1993. However, since the appeals were, upon application by the respondent, heard under the Court’s general procedure pursuant to the order of June 26, 1998, all of the appellant’s reasonable and justified costs associated with the appeals shall be paid by the respondent.
Revised at Ottawa, Canada, this 26th day of February 1999.
“P.R. Dussault”
J.T.C.C.
[OFFICIAL ENGLISH TRANSLATION]
Translation certified true on this 31st day of October 1999.
Erich Klein, Revisor