Date: 20010724
Docket: 2000-2720-IT-I
BETWEEN:
MOHAMED KARMALI,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
____________________________________________________________________
Agent for the Appellant: Richard Rooney
Counsel for the Respondent: Suzanne M. Bruce
____________________________________________________________________
Reasons for Judgment
(Delivered orally from the Bench, at Toronto, Ontario, on June 8, 2001)
McArthur J.
[1] As a result of an audit in respect of condominium rental losses, the Minister of National Revenue reassessed the Appellant for the 1995 and 1996 taxation years disallowing the deduction of losses and undepreciated capital cost balance at the end of 1996. The Appellant appeals those reassessments. He is a medical doctor presently with the Federal Department of Health and did not attend the hearing. The evidence was presented by Barry Flodder, the Appellant's accountant of 15 years. Richard Rooney, C.A. acted as the Appellant's agent and he was given time to attempt to contact the Appellant to attend the hearing but being unable to reach him, the agent chose to proceed.
[2] During the 1995 and 1996 taxation years, the Appellant was employed as a medical doctor at Toronto's Sick Children's Hospital. The following assumptions of fact in the Reply to the Notice of Appeal were agreed to:
7(b) the Appellant acquired a unit in a condominium building located at the Atriums in Kanata, Ontario (the "Property") in 1987 for a total purchase price of $131,998 as a tax shelter;
7(c) the property was financed 99% by a mortgage and a promissory note in the total amount of $130,998;
7(d) the Appellant paid a premium to obtain special financing and revenue guarantees in respect of the Property;
7(e) the premium was amortized over five years, increasing the rental losses reported for those years;
7(f) beginning in 1987, the Appellant rented the Property;
7(g) from 1995 to 1996, the Appellant reported rental income and expenses and losses from the Property as follows:
YEAR INCOME INTEREST TOTAL
EXPENSE EXPENSES LOSS
1995 $5,335 $8,038 $10,291 $4,956
1996 $4,893 $6,874 $ 9,146 $4,253
The income referred to above was reported by the Appellant in his income tax returns and according to Mr. Flodder, that income is misleading in that his unit had a higher income for those years, I believe in the neighbourhood of $9,000. With the condominium pooling arrangements, however, the income was reduced to the figures claimed. The Appellant was not actively involved in the rental operation.
7(j) the Appellant also reported net rental losses for the previous eight years as follows:
YEAR RENTAL LOSS CLAIMED
1987 $17,168
1988 $14,193
1989 $10,229
1990 $ 9, 644
1991 $12,516
1992 $ 7,654
1993 $ 7,172
1994 $ 6,570
These rental losses claimed total approximately $85,000.
[3] There are many reasons for the lower rents and higher costs than projected or anticipated by the Appellant, including poor rental management, shoddy construction of the building that became expensive, the vendor went bankrupt and could not honour his rental guarantees, an expensive lawsuit followed, and so on. By claiming the losses, the Appellant reduced his income from other sources. Finally, the Appellant sold the property in February 1998. I believe the sale price was $79,000.
[4] Mr. Flodder stated that he was more familiar with the figures than the Appellant which is likely. He presented a Rental Questionnaire (Exhibit A-1) purportedly prepared by the Appellant and the first question and answer of that Questionnaire is as follows:
1. What was the initial purpose of acquiring the property?
The initial purpose was to earn income on an ongoing basis. The expectation of earning income, which was the only motive for purchasing the property, was based on the original sales pitch of the developer. There was clearly no interest in the personal use of the property since I was then and remain now a resident of Toronto, whereas the property is in Ottawa. I have no relatives living in Ottawa.
The Appellant based his decision to purchase, apparently, on a one-page proforma, (Exhibit A-2), prepared by the developer, which projects the taxation years 1986, 1987, 1988 and 1989. The property was not rented in 1986. The proforma, if I can call it that, demonstrates a taxable income loss after 1989 of $38,180 and tax savings of $19,929. Under the heading "After Tax Cash Flow Statement" a loss of $3,215 at the end of 1989 is indicated. Also, under the heading "Projected Gain on Sale of Unit at Various Rates of Appreciation (Assuming a Sale in 1990)" it indicates a profit of $40,197 as the after-tax cash position on the sale, assuming an appreciation of 8% per year.
[5] Mr. Flodder prepared a schedule of rental income and loss (Exhibit A-3), continuing the builder/vendor's schedule beyond 1989, and it reflected a positive rental income at the end of 1996 of $3,041. In fact, in 1996, the actual loss was $4,253. The issues to be determined are whether the property was acquired by the Appellant for the purpose of gaining or producing income; whether the Appellant had a reasonable expectation of profit from the rental of the property for the years 1995 and 1996; whether the rental expense were incurred by the Appellant for gaining and producing income from a business or property; and finally, in the alternative, whether the disallowed rental expenses were reasonable in the circumstances. As stated, the Appellant was not present to testify as to his reasons for purchasing the unit.
[6] The evidence presented was to the effect that the Appellant purchased the unit to earn rental income. I find as a fact that he paid the $131,000 financing down to $66,000 by February 1998 when the property was sold. The Notice of Appeal prepared by Mr. Flodder included the following which I accept as being accurate:
By December 31, 1995 approximately 56% of the original debt with respect to the property had been retired.
By mid 1996, vacancy rates were decreasing and rental rates were increasing. Many programs initiated by the condominium board to reduce operating costs were starting to take effect.
Both the condominium board and Dr. Karmali took the steps necessary to reduce costs and maximize income during this period.
...
Although the property was sold in February 1998, projections show the property would have shown profits of $778 in 1998 and $2,513 in 1999.
[7] The facts in these appeals are similar to those dealt with by Bowie J. in von Heymann v. The Queen[1] wherein the taxpayer, a medical doctor, acquired an interest in a limited partnership which in turn held an interest in an apartment complex. The acquisition of such interest was completely financed by borrowed funds. In assessing the taxpayer, the Minister denied the deduction of his share of the partnership losses and of interest paid by him on money borrowed. The Minister took the position that (i) such interest was not a source of income; (ii) the taxpayer had no reasonable expectation of profit in view of the very large financing costs; and (iii) he had participated in the partnership to obtain tax advantages and not to earn income. While I do not consider myself bound by this decision, I agree with the reasoning and adopt that as my own in the present judgment. Bowie J. said at paragraph 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.
[8] Judge Bowie also relied on Stewart v. The Queen.[2] The taxpayer purchased real estate with a 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 and not income. In the present appeals, the Appellant repaid more than 50% of the mortgage principal and in the von Heymann appeal, the Appellant had repaid all of the principal on a $6,000 loan. Bowie J. then went on to quote Robertson J. in Mohammed v. The Queen[3] and further stated as follows:
... It does not appear to me that the Appellant in this case could satisfy that test. (the test set out in Mohammed). He made no payments on the principal during the first five years, although his income was considerably in excess of $200,000 per year.
[9] The Queen v. Milewski[4] is a more recent decision of the Federal Court of Appeal. In that case, the Court held that the test was satisfied because it was reasonable to purchase real estate and amortize the purchase price over 25 years. Rothstein J. stated at page 6560:
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.
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.
I conclude that the present Appellant satisfied the fullness of time test as stated in Milewski to establish a reasonable expectation of profit.
[10] I now turn 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 and that the purpose of the acquisition was not to produce income, but to acquire a capital gain. I continue with the quote of Judge Bowie in von Heymann:
... 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 a venture in the nature of trade in the present case. ... I agree with that view. See Regal Heights Limited v. M.N.R. Any profit on resale would, therefore, be on income account.
Judge Bowie then went on to allow the appeals.
[11] In the present appeals, I find as a fact that the Appellant paid down more that 50% of the financing before the relevant years. He purchased it with a joint intention of selling at a profit after it appreciated over the years, and in the meantime earning rental income, having paid down the indebtedness. The Minister would have had a stronger position in the earlier years but chose to audit the Appellant after more than 10 years of his ownership. By this time, there is little doubt he had a reasonable expectation of profit. The accountants projected a profit in 1998, the year it was sold.
[12] It is to be noted that Stewart and Allen v. The Queen have received leave to appeal to the Supreme Court of Canada. The decisions of the Supreme Court may give us guidance in what has become somewhat of a complex issue.
[13] For these reasons, the appeals are allowed and the assessments are referred back to the Minister for reconsideration and reassessment on the basis that the Appellant is entitled to the losses claimed as well as costs, if any.
Signed at Ottawa, Canada, this 24th day of July, 2001.
"C.H. McArthur"
J.T.C.C.
COURT FILE NO.: 2000-2720(IT)I
STYLE OF CAUSE: Mohamed Karmali & Her Majesty the Queen
PLACE OF HEARING: Toronto, Ontario
DATE OF HEARING: June 7, 2001
REASONS FOR JUDGMENT BY: The Honourable Judge C.H. McArthur
DATE OF JUDGMENT: June 13, 2001
APPEARANCES:
Agent for the Appellant: Richard Rooney
Counsel for the Respondent: Suzanne M. Bruce
COUNSEL OF RECORD:
For the Appellant:
Name: N/A
Firm:
For the Respondent: Morris Rosenberg
Deputy Attorney General of Canada
Ottawa, Canada