Date: 20010126
Docket: 98-2063-IT-G
BETWEEN:
JOBST von HEYMANN,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Bowie J.
[1] These appeals are from income tax assessments for the taxation years 1992, 1993 and 1994. The point in issue is a narrow one, and by no means novel. The Appellant claims that in computing his income under section 3 of the Income Tax Act (the Act), he is entitled to deduct from his other income his share of the losses sustained by a limited partnership in which he held an interest, and that pursuant to paragraph 20(1)(c) the interest paid by him on the money that he borrowed to purchase that interest may be included in computing those losses. The Respondent's position is that he may not deduct these amounts because his partnership interest was not in those years "a source of income" within the meaning of that expression as it is used in section 3 of the Act.
[2] The Appellant is a medical doctor with a busy practice in Port Elgin, Ontario. During the years in question he had a substantial income, but from it he had to provide a retirement income for himself and his wife. He and his wife planned their investments together, and they tried to diversify them. In the summer of 1990 the syndication of a group of condominium apartments in Waterloo, Ontario called Northlake Trace came to their attention as a potential investment. It consisted of a group of 10 apartment buildings, each having three stories, containing among them a total of 110 apartments. It was located in a good neighbourhood, close to universities and an area of good quality single family houses.
[3] Mr. Martin, the principal of the Datile group of companies, testified that Northlake Trace was recommended to him as good quality apartment complex which was well laid out, well landscaped, and in good physical condition. It was, however, poorly managed, and it was not producing the rental income of which it was capable. As such, it suited the business plan of Mr. Martin's group of companies, and so he arranged to purchase the buildings. Of the 110 suites making up the complex, 56 were acquired by a limited partnership called Northlake Trace Limited Partnership (the partnership).
[4] The following particulars concerning the partnership, and the Appellant's purchase of an interest in it, are agreed upon by the parties for the purposes of these appeals.
5. Pursuant to an Assumption and General Services Agreement (the "Purchase Agreement"), the Partnership agreed to acquire 85 condominium suites in Northlake Trace and interests in related assets from Northlake Trace Investments Inc. (the "Promoter"). In addition, pursuant to the Purchase Agreement, the Promoter agreed to provide certain services to the Partnership and its partners.
6. Pursuant to an offering memorandum dated September 12, 1990 (the "OM"), the Partnership offered units in its capital to investors.
7. The purchase price for a unit in the Partnership varied from $174,000 to $291,000. The purchase price varied because under the agreement governing the Partnership a limited partner was entitled to have particular condominium suites in Northlake Trace distributed to him under certain conditions.
8. Pursuant to the OM, 28 individuals subscribed for 28 units in the Partnership.
9. The 28 investors (including the Appellant) paid the aggregate amount of $5,005,308 to acquire their units in the Partnership. In addition, the investors (including the Appellant) paid the aggregate amount of $141,692 to the Promoter as financing arranging fees and an interest rate buy-down payment.
10. The investors satisfied the purchase price for their units in the Partnership and the investor services as to $4,979,000 in cash and as to $168,000 by the delivery of promissory notes (the "Secured Note B") to the Promoter.
11. On December 31, 1990, the Partnership acquired 56 condominium units in Northlake Trace from the Promoter for an aggregate purchase price of $3,967,704. In addition, the Partnership paid the Promoter $518,764 as fees for establishing and financing the Partnership, financial reporting and creating a maintenance reserve and $518,840 as fees relating to the issue of Partnership units.
12. The $3,967,704 paid by the Partnership for the 56 condominium units was allocated as follows:
land $514,700
buildings $3,307,404
chattels $112,000
paving $33,600
13. On December 10, 1990, the Appellant subscribed for a unit in the Partnership in accordance with the terms and conditions for such subscription set out in the OM. As a result of his ownership of the unit, the Appellant had the right to acquire two two-bedroom condominium suites in Northlake Trace from the Partnership.
14. The Appellant paid $184,000 for his unit in the Partnership and related services. The purchase price was payable as to $178,000 in cash and the remainder by having the Appellant provide to the Partnership a promissory note (the "Secured Note B") in the amount of $6,000.
15. The Secured B Note was secured by a collateral second mortgage on the condominium suites that the Appellant had the right to acquire. A copy of the Secured Note B is found together with the Appellant's Subscription Agreement at Tab 8 of the Joint Book of Documents.
16. In order to fund the cash portion of the purchase price for his Partnership unit, the Appellant borrowed $138,000 from Investors Group Trust Co. Ltd. (the "Secured Loan"). The Secured Loan bore interest at the rate of 13% compounded semi-annually and was repayable on January 7, 1996. The Secured Loan was secured by a collateral first mortgage on the condominium suites in Northlake Trace that the Appellant had the right to acquire. A copy of the Secured Loan promissory Note is found at Tab 10 of the Joint Book of Documents.
17. In addition to the Secured Loan, the Appellant borrowed $40,000 from the Bank of Montreal (the "Equity Loan") in order to fund the remaining cash portion of the purchase price for his unit in the Partnership. The Equity Loan is a demand loan that bears interest at the rate of prime plus 1½% and is payable as to interest only for five years.
18. The Secured Loan, the Equity Loan and the Secured Note B are full-recourse obligations of the Appellant.
19. The Partnership determined that it had the following losses for income tax purpose for each of its 1992, 1993 and 1994 taxation years and allocated the following amounts to the Appellant:
|
Taxation Year |
Operating Loss |
Loss Allocated to Appellant |
|
1992 |
« $23,651 » |
« $847 » |
|
1993 |
« $110,395 » |
« $3,662 » |
|
1994 |
« $75,688 » |
« $2,918 » |
20. The Appellant deducted his pro rata share of the Partnership's loss for each fiscal period in computing his income for the relevant Taxation Years.
21. In each of the Taxation Years, the Appellant paid interest on the Secured Loan, the Equity Loan and the Secured Note B and also paid amounts relating to certain fees and carrying charges (collectively, the "Fees") in connection with his investment in the Partnership. The amount of the payments in respect of interest expense and the Fees is set out in the chart below:
|
|
Taxation Year |
||
|
Deduction |
1992 |
1993 |
1994 |
|
Interest – Secured Loan |
$17,324 |
$17,197 |
$17,056 |
|
Interest – B Note |
$600 |
$600 |
$600 |
|
Interest - Equity Loan |
$3,588 |
$2,998 |
$3,290 |
|
Fees/Carrying Charges |
$1,052 |
$1,006 |
$966 |
|
Total Deductions |
$22,564 |
$21,801 |
$21,912 |
22. The Appellant deducted $22,564, $23,409 and $23,478 in respect of the foregoing expenses in computing his income for his 1992, 1993 and 1994 taxation years.
23. The Minister of National Revenue (the "Minister") disallowed the following amounts relating to the Partnership investment of the Appellant in computing the income of the Appellant for the Appellant's 1992 to 1994 taxation years:
1992 1993 1994
Limited Partnership Loss $847 $3,662 $2,918
Interest and carrying charges $22,564 $23,409 $20,188
[5] While they were considering this investment the von Heymanns were shown certain projections of the financial results that could be expected from the purchase of an interest in the partnership, if that interest were financed to the extent of 100%, as described in the agreed facts. They were also shown projections of the results that would flow from a purchase on that basis, followed by a hypothetical sale after five years, based on assumed rates of appreciation of the underlying real estate varying from 6% per annum to 16% per annum. The losses that the Appellant incurred, therefore, were entirely predictable, as were his interest payments. Dr. von Heymann's evidence as a whole satisfies me that the potential to make a profit on resale of the unit (or the two condominium units) when real estate values increased, and the prospect of holding until it became an income-producing asset both influenced his decision to buy, and in more or less equal degrees. He did not buy with any definite intention to sell within any specific time frame.
[6] The basis of the Minister's assessment of the Appellant is found in paragraph 10(b) to (h) of the Reply:
(b) The Appellant's investment in the Partnership was completely financed by borrowed funds;
(c) the financial projections attached to the Offering Memorandum show that a limited partner in the Partnership was expected to sustain investment losses each year from 1990 to 1995;
(d) the Appellant participated in the Partnership for the purposes of obtaining tax advantages to generate losses to offset other sources of income and not for the purpose of earning income therefrom;
(e) the Appellant did not have a reasonable expectation of profit in respect of the Partnership investment;
(f) the partnership investment was not a source of income of the Appellant;
(h)[sic]the Amounts claimed by the Appellant relating to the Partnership investment were not reasonable in the circumstances.
The last ground was quite properly abandoned by counsel at the trial.
[7] At trial, counsel for the Respondent took the position that the partnership unit could not be considered a source of income to the Appellant because he could have had no reasonable expectation of a profit in his hands, that is at the investor level, from rental income, given the very large financing costs. Nor could the unit be a source of income to arise out of a resale at an enhanced price, because that would give rise to a capital gain and not income. He conceded that the facts of this case so far as they concern potential income from rent, are indistinguishable from those in Allen v. The Queen and Milewski v. The Queen,[1] which at that time was under appeal to the Federal Court of Appeal. In that case Judge Bowman of this Court rejected the Minister's position that the partnership did not carry on a business. He described it as being "... wrong as a matter of logic, law and common sense". His decision has since been affirmed by the Court of Appeal,[2] which held that the reasonable expectation of profit test had been satisfactorily met by the taxpayers where, having financed the purchase of their partnership interests to the extent of 99% with borrowed funds, they were paying the interest and principal on those loans on a 25-year amortization. In giving the principal Reasons for Judgment, with which both the other members of the Court agreed, Rothstein J. said this:
[6] Counsel for the Minister concedes that to meet the reasonable expectation of profit test, an investment need not be currently profitable. However, he does not indicate what principle the Court should adopt to determine when the profit must be expected to satisfy the test. He says it will depend on the facts of each case. However, to follow this approach without further guidelines, the Court would be left without a principled basis to determine when profit must be expected in order to meet the test. The determination would essentially be arbitrary. This is unsatisfactory.
[7] If there was no indication of any principal repayment or the annual interest expense results in losses for an indefinite period of time, i.e., an unusually long amortization period or, as in Stewart, there was no profit expected over the intended holding period, there might be no reasonable expectation of profit. However, those are not the facts here.
[8] Here, the amortization period was 25 years. That is not an unusual amortization period for long-term investments in real estate. As the principal is paid down, the interest expense decreases and, all other things being equal, profitability will "in the fullness of time" be achieved. The Tax Court Judge found the investment was long-term in nature. In these circumstances, I think the reasonable expectation of profit test was met.
[8] Following the release of the Reasons for Judgment of the Federal Court of Appeal in Milewski, I invited written submissions from counsel as to its application to this case. Counsel for the Respondent, quite understandably, did not suggest that the Appellant had failed to meet the "fullness of time" test established by the Federal Court of Appeal in Milewski. Instead he advanced what I might call the secondary argument, that the Appellant purchased the unit for resale, and the resale would give rise to a capital gain, not income. He relied on Stewart v. The Queen.[3] There the taxpayer purchased real estate with the specific intention to resell at a higher price. It was held that he did not have a source of income, because no rental profit would be realized within the time that he intended to hold the property, and the resale would give rise to a capital gain, not income.
[9] In the present case the Appellant had repaid all the principal on the $6,000 loan, by the end of the fifth year. He had paid $32,000 of the $40,000 loan by April 2000, and the balance of that loan, he said, would be repaid by January 2001, which is the end of the tenth year. The principal amount of the secured loan was originally $138,000. By the time of the trial in April 2000, it had been reduced to $106,000, and the Appellant had reduced the amortization period from the original 25 years to 19 years, because he wished to have the debt retired by the time he reached 65 years of age.
[10] Robertson J., speaking for a unanimous Federal Court of Appeal, said in Mohammad v. The Queen:
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.
It does not appear to me that the Appellant in this case could satisfy that test. He made no payments on the principal during the first five years, although his income was considerably in excess of $200,000 per year.
[11] Milewski is a more recent decision of the Federal Court of Appeal, however, and its facts are indistinguishable from those before me. In that case the Court held that the test was satisfied, because it was reasonable to purchase real estate upon a 25-year amortization of the purchase price. Dr. von Heymann will have retired the purchase-money loans in this case at the end of 19 years. I conclude, therefore, that the Appellant satisfies the "fullness of time" test to establish a reasonable expectation of profit.
[12] I turn now to the Respondent's argument that in this case, as in Stewart, the Appellant purchased the property with the intention of reselling it at an enhanced price even before it could become profitable, so that the purpose of the acquisition was not to produce income, but to produce a capital gain. First, I am doubtful that this argument is open to the Respondent on the pleadings. For present purposes, however, I will assume that it is. As I have already found, the Appellant was motivated in the purchase of his interest in the partnership by both the possibility of income in the long run and the possibility of selling the property at a profit once the real estate market recovered. Counsel for the Appellant argued that "there is strong evidence to support a finding that the Appellant was engaged in an adventure in the nature of trade in the present case ...". I agree with that view: see Regal Heights Ltd. v. M.N.R.[5] Any profit on resale would therefore be on income account.
[13] The appeals are allowed. The assessments are referred back to the Minister of National Revenue for reconsideration and reassessment allowing the Appellant the benefit of the losses claimed. The Appellant is entitled to his costs.
Signed at Ottawa, Canada, this 26th day of January, 2001.
"E.A. Bowie"
J.T.C.C.