Tax Court of Canada Judgments

Date: 20000215

Docket: 98-1562-IT-I

BETWEEN:

HUSSEIN EL-HENNAWY,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Sarchuk J.T.C.C.

[1] These are appeals by Hussein El-Hennawy from assessments of tax with respect to his 1993, 1994 and 1995 taxation years. In computing income for those years, the Appellant claimed rental losses from a property in Cairo, Egypt in the amounts of $36,838.22, $38,837.60 and $38,332.68, respectively. The Minister of National Revenue disallowed the deductions on the basis of the following assumptions of fact:

(a) the Appellant purchased the Property in 1984 from his brothers and sisters for 300,000 Egyptian pounds;

(b) the Appellant financed 80% of the purchase price with a first mortgage from his brothers and sisters at an interest rate of 9% per year;

(c) the Appellant also obtained a second mortgage, at any interest rate of 12%, from his brothers and sisters to cover any amounts not paid on the first mortgage;

(d) the Appellant has not reduced the principal amounts of the mortgages on the Property;

(e) before, and at, the time the Appellant purchased the Property and during the years in question, the Property was subject to government rent controls;

(f) the Appellant reported rental losses in respect of the Property for the 1987 to 1992 taxation years and the 1996 taxation year, in the following amounts:

Gross Total Net

Year Income Expenses Loss

1987 $4,708 $40,193 $35,485

1988 $4,406 $37,154 $32,748

1989 $4,567 $38,948 $34,381

1990 $4,110 $42,290 $38,180

1991 $4,146 $40,558 $36,412

1992 $4,138 $42,946 $38,808

1996 $4,905 $44,041 $39,136

(g) for the 1993, 1994 and 1995 taxation years, the Appellant reported gross rental income, expenses (before capital cost allowance) and losses from the rental of the Property as follows:

	1993	1994	1995
Gross Rental Income	$4,550.10	$4,883.89	$4,778.48
Expenses
Interest	$39,988.77	$39,796.89	$39,958.23
Property taxes	510.66	548.12	536.29
Superintendent & management	888.89
Salaries, wages		867.48	848.64
Rent collection, bookkeeping, preparation of financial statements		2,509.00	1,768.00
Total Expenses	$41,388.32	$43,721.49	$43,111.16
Net Rental Loss	$36,838.22	$38,837.60	$38,332.68

Appellant's position

[2] The Appellant was the sole witness called. He does not dispute the facts set out in the foregoing assumptions but says that they do not reflect all of the relevant circumstances. He testified that the property had originally been acquired by his father and was at all times held by him in his capacity as natural custodian for his five children including the Appellant whose share was 25%. In 1973, to obtain funds to permit him to emigrate to Canada the Appellant sold his share in the property to his sisters and brothers for the equivalent of CAN $2,000.[1] In August 1985, the Appellant entered into an agreement to purchase the property from his siblings for 300,000 Egyptian Pounds (300,000 L.E.) payable by way of 60,000 L.E. in cash together with a first mortgage back to the vendors for the balance of the purchase price. The mortgage was for a term of 25 years and carried interest at an annual rate of 9% calculated annually, not in advance. At the time of his acquisition, the property consisted of 19 rental units, 14 residential and five commercial.[2]

[3] According to the Appellant, Egypt at that time operated under a controlled economy, one aspect of which was that wages and prices including rental rates were under strict control and landlords were not permitted to increase the rates in any circumstances. All indications at the time of his purchase were that rent controls would be eased off gradually and in time, completely abolished. He specifically observed that the conflict between Israel and Egypt had ended, peace accords were in place, the Egyptian economy was reviving and as a result, the government had moved to remove certain price and wage controls albeit not yet with respect to rental properties. The Appellant was aware that because of rent controls there was limited construction and, therefore, almost no rental accommodation was available. In fact, to circumvent the controls, many property owners treated vacant units as "furnished" thus enabling them to charge 10 to 12 times more than the average rent for similar controlled units. The Appellant maintains he was convinced that rent controls would be "liberated" and "wanted to get in on the ground floor" before the prices of real property escalated. Acting on the assumption that controls would be a thing of the past in one or two years, he projected rental incomes based on the rents being paid at that time for the so-called "furnished" suites and concluded that within three years of the removal of rent controls, the property would commence to produce "positive income". He also said that he was able to negotiate a substantially lower price than the appraised value of the property which was 500,000 L.E.[3] This price was available to him in part because his siblings were having cash flow problems and an outstanding debt and were in a hurry to dispose of the property. Satisfied with his assessment of the situation the Appellant purchased the property.

[4] Unfortunately for the Appellant, events did not proceed quite as anticipated. Rent controls were amended but not until 1990 and then only to a limited extent. Specifically, new units constructed in 1990 and thereafter were not subject to controls and landlords were allowed to charge rent for these units at fair market value. Rent controls on existing units remained in place until 1997 when increases to basic rent of 10% for that year and 10% for 1998 were permitted. As a result of the government's decision to exempt units constructed in 1990 and thereafter from rent controls, the Appellant decided to expand by adding five additional residential units to the building. The cost was approximately US $95,000 (CAN $128,700 in 1990) raised by way of what he described as a "vendor take back second mortgage"[4] on the property bearing interest at the rate of 12% per annum. The Appellant says these units were constructed with the intention that they would be sold and the proceeds applied to reduce the overall financing on the property. However, by the time they were completed in 1993 there was not as much demand as anticipated as a result of which he offered potential purchasers a five-year "rent to purchase" option which he said entitled them to acquire the units up to December 31, 1997 and if purchased, to apply the annual rent of US $1,500 per unit towards the purchase price.[5] In this fashion, he managed to rent two of the units in 1993, one in 1994 and the last two in 1995. In 1997, two of the "tenants" decided to purchase the units and the transactions were closed at the beginning of 1998. The remaining three did not want to purchase the units and these remained rented at the current market rate.[6] In addition to the two units which were sold, the Appellant also effected the sale of a commercial unit in the latter part of 1998. The amounts received for the two new units were US $45,000 and US $46,150 while the commercial unit was sold for US $48,000.[7]

[5] The Appellant testified that in 1998 his gross income from the properties was CAN $41,757.07 and his expenses were $21,270.31. He claimed capital cost allowance (CCA) amounting to $18,721.30 and reported net income of $1,765.41.[8] He conceded that the gross income for 1998 included the "option money I collected" in 1995, 1996 and 1997 with respect to the three new units which remained unsold and that these amounts had not been reported in those years because they were treated as "capital, as part of the purchase price".

Conclusion

[6] The issue before me is whether the Appellant has, on a balance of probabilities, demonstrated that he carried on the rental business with a reasonable expectation of profit. In Moldowan v. The Queen,[9] the Court stated: "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 to business. The deductibility of expenses for the determination of property and business income is found in subsection 9(1) of the Income Tax Act. It provides:

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.

In addition to the foregoing, section 18 of the Act legislates specific statutory limitations on expense deductions. Paragraph 18(1)(a) denies a deduction unless the amount is paid or incurred for the purpose of gaining or producing income while paragraph 18(1)(h) limits the deductibility of personal or living expenses which are defined in subsection 248(1) of the Act to exclude expenses in connection with property, unless the property is maintained in connection with a business carried on for profit or with a reasonable expectation of profit.

[7] A number of recent decisions read together suggest that in certain cases even though there may be a genuine intention for the pursuit of profit, where such intention is unrealistic and the expectation unreasonable, the activity will not be accepted as a business and that indeed, is the Respondent's position. It is also clear that if the Court concludes that a taxpayer's motives were strictly commercial, it should not substitute its business judgment for that of the taxpayer unless the expectations are "patently unreasonable".

[8] I am satisfied that the present case falls into the category which involves essentially commercial operations without any element of personal benefit. There was an oblique reference made on behalf of the Respondent to the fact that the Appellant's siblings were tenants in this building, however, considering the fact that the rents all tenants were paying were controlled by the government and that in fact the siblings' rents were among the highest puts this issue to rest.

[9] The Appellant is an engineer by profession and at all relevant times was employed by Ontario Hydro in that capacity. His responsibilities included feasibility studies, site selection as well as construction and project management. As well in 1982, he founded a real estate and investment company, MIG Mississauga Ontario, through which he has been involved in a number of projects.[10] It is fair to say that the Appellant is an experienced businessman knowledgeable in the real estate field. The decision to acquire the Cairo property was taken by him in good faith following an assessment of the facts available and with reason to anticipate that rent controls would soon be removed. He was wrong. In Tonn v. The Queen,[11] Linden J.A. stated that:

But do the Act's purposes suggest that deductions of losses from bona fide businesses be disallowed solely because the taxpayer made a bad judgment call? I do not think so. The tax system has every interest in investigating the bona fides of a taxpayer's dealings in certain situations, but it should not discourage, or penalize, honest but erroneous business decisions. The tax system does not tax on the basis of a taxpayer's business acumen with deductions extended to the wise and withheld from the foolish. Rather, the Act taxes on the basis of the economic situation of the taxpayer – as it is in fact, and not as it should be subject to what is said below.

The fact that all of the elements necessary to make the acquisition a profitable one did not occur as soon as anticipated can only be categorized as an over-optimistic assessment of the immediacy and extent of the removal of rent controls. This Appellant's entitlement to the deduction of the expenses incurred should not be determined solely on this basis. In my view, the actions taken by him to cut his losses by commencing the construction of additional units, not subject to controls, in order to produce income from their sale to be applied to the reduction of the principal amounts of the mortgages must also be taken into account.

[10] As was observed in Mohammed v. The Queen:[12]

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.      [Emphasis added]

[11] The evidence as a whole satisfies me that the Appellant, once the initial concept failed to materialize immediately, proceeded with a reasonably realistic alternative plan to reduce the principal amounts of the borrowed moneys. While this took longer than anticipated, it cannot be said that there is no objective evidence of both his intention and ability to pay down a meaningful portion of the acquisition costs within a reasonable period of time.

[12] For these reasons, the Appellant is entitled to deduct the rental losses claimed and the appeals are allowed, with costs.

Signed at Ottawa, Canada, this 15th day of February, 2000.

"A.A. Sarchuk"

J.T.C.C.

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