Date: 19990812
Dockets: 97-3096-IT-G; 97-3106-IT-G
BETWEEN:
THOMAS J. ALLEN, EDWARD R. MILEWSKI,
Appellants,
and
HER MAJESTY THE QUEEN,
Respondent,
Reasons for Judgment
Bowman, J.T.C.C.
[1] These appeals were heard together on the basis of a Partial Agreed Statement of Facts, as well as viva voce testimony. The appellants invested in units of a limited partnership that carried on the business of renting apartments. It is admitted that the partnership business was carried on with a reasonable expectation of profit. The respondent's position is, however, that because the financing arrangements for the investment involved the payment of interest by the individual investors that exceeded the income from the limited partnership this justified invoking the "no reasonable expectation of profit" ("NREOP") doctrine.
[2] The Partial Statement of Agreed Facts reads as follows:
PARTIAL STATEMENT OF AGREED FACTS
For purposes of hearing Appeal Nos. 97-3106(IT)G and 97-3096(IT)G before the Tax Court of Canada, the Appellants and Respondent agree on the following facts:
1. The Appellants are individuals resident in Canada.
2. The Appellants are limited partners in the Sherwood Gate Limited Partnership (the "Partnership"), a limited partnership formed and subsisting under the laws of the Province of Ontario.
3. The Partnership was formed for the purposes of owning and renting a 12-storey, 118 unit residential condominium building located at 30 Chapman Court, London, Ontario (the "Property"). The Partnership continues to carry on its rental operations.
4. The Property was registered as a condominium under the Condominium Act (Ontario) on October 14, 1993.
5. The Property was acquired by the Partnership from Chapman Court Limited in three traunches on November 30, 1993 (46 units), December 22, 1993 (50 units) and December 31, 1993 (22 units).
6. The financial projections attached to a Confidential Offering Memorandum dated July 22, 1993 (the "Offering Memorandum") projected that the Partnership would have an initial loss in its 1993 taxation year, no income or loss in its 1994 and 1995 taxation years and income in its 1996 and 1997 years all determined after claiming the maximum available capital cost allowance.
Milewski Purchase
7. The Appellant Edward R. Milewski acquired three units in the Partnership (the "Partnership Interest") in accordance with the terms of the Offering Memorandum by executing two Subscription Agreements dated the 24th day of September, 1993 and the 22nd day of December, 1993, respectively.
8. The purchase price of Mr. Milewski's Partnership Interest was $351,745. Mr. Milewski paid $3,000 from his own funds and paid the balance using money he borrowed from Security Home Mortgage Corporation ($298,984.25), an arm's length commercial lender, and Chapman Court Limited ($49,761.75), the vendor of the property.
9. The amounts borrowed by Mr. Milewski were evidenced by three promissory notes (the "Equity Notes") in favour of Security Home Mortgage Corporation and three promissory notes (the "Second Equity Notes") in favour of Chapman Court Limited. Two of the Equity Notes were in principal amount of $99,369.75 each of the third was in the principal amount of $100,244.75. Two of the Second Equity Notes were in the principal amount of $16,535.75 each and the third was in the principal amount of $16,690.25. The Equity Notes and the Second Equity Notes were secured by first and second collateral mortgages registered against the Property, respectively.
10. The Partnership Interest entitled Mr. Milewski to acquire three specific condominium units in the Property (units 806, 1202 and 1209) from the Partnership in the event that the Appellant chooses to withdraw from the Partnership or if the Partnership is wound-up.
11. In filing his T1 income tax return for his 1993 taxation year, Mr. Milewski deducted $30,690 representing his share of the net loss of the Partnership allocated to its members. In addition, the Appellant deducted interest on the Equity Notes and the Second Equity Notes in the aggregate amount of $1,554 and partner services charges in the amount of $3,746.
12. In filing his T1 income tax return for his 1994 taxation year, Mr. Milewski was not allocated any income or loss by the Partnership. The Appellant deducted interest on the Equity Notes and the Second Equity Notes in the aggregate amount of $22,827.20 and partner services charges in the amount of $3,819.
13. The Minister of National [Revenue] (the "Minister") reassessed Mr. Milewski's 1993 taxation year to deny the deduction of the loss of Mr. Milewski arising from the Partnership in the amount of $30,690 and the interest totalling $1,554.
14. The Minister reassessed the 1994 taxation year of Mr. Milewski to deny the deduction of the interest totalling $15,812.
Allen Purchase
15. In January, 1994, the Appellant Thomas Allen acquired two units in the Partnership in accordance with the terms of the Offering Memorandum.
16. The purchase price of Mr. Allen's Partnership Interest was $238,960. Mr. Allen paid $2,000 from his own funds and paid the balance using money he borrowed from Security Home Mortgage Corporation ($203,116), an arm's length commercial lender, and Chapman Court Limited ($33,844), the vendor of the Property.
17. The amounts borrowed by Mr. Allen were evidenced by two Equity Notes in favour of Security Home Mortgage Corporation and two Second Equity Notes in favour of Chapman Court Limited. The Equity Notes were in the principal amount of $101,558 each and the Second Equity Notes were in the principal amount of $16,922 each. The Equity Notes and the Second Equity Notes were secured by first and second collateral mortgages registered against the Property, respectively.
18. The Partnership Interest entitles Mr. Allen to acquire two specific condominium units in the Property (units 205 and 705) from the Partnership in the event that Mr. Allen chooses to withdraw from the Partnership or if the Partnership is wound-up.
19. In filing his T1 income tax return for his 1994 taxation year, Mr. Allen was not allocated any income or loss by the Partnership. Mr. Allen deducted interest on the Equity Notes and the Second Equity Notes in the aggregate amount of $12,141.42 and partner services charges in the amount of $2,596.
20. On August 6, 1996, the Minister reassessed the 1994 taxation year of Mr. Allen to deny the deduction of interest totalling $12,141.
[3] Before dealing with the rest of the evidence not covered by the agreed statement of facts, it is important that the basis of the assessment and the position of the respondent be clearly set out. The respondent puts her case solely and squarely on the doctrine NREOP. In both replies to the notice of appeal it is stated that the Minister based the reassessment "on the conclusion that the Appellant did not have a reasonable expectation of profit for the rental operation".
[4] The respondent states that the issue is "whether there was a reasonable expectation of profit from the rental operation".
[5] In the reasons advanced for the respondent's position it is stated that the rental losses claimed by the appellant together with the related interest expenses were disallowed "since the rental operation had no reasonable expectation of profit and did not constitute a source of income".
[6] I mention this at the outset because it is the only case the appellants were called upon to meet. There is no suggestion of artificiality or tax avoidance. It is not alleged that the interest paid was unreasonable and it is clear that there was no personal element. Moreover, as stated above, it is admitted that the rental business carried on by the partnership had a reasonable expectation of profit.
[7] The appellant, Mr. Milewski, was a stockbroker who had a substantial income in the years in question. The appellant, Mr. Allen, is a police officer. Mr. Robert J. Thiessen, the president of the promoter, Promittere Capital Group testified and described the manner in which the investment was structured. The partnership, Sherwood Gate Limited Partnership, had about 55 limited partners, including the appellant. The general partner, 1012141 Ontario Limited, was wholly owned by the promoter.
[8] $13,770,585 was raised by the offering of units in the partnership. Of this, $10,796,918 was for the land and buildings, appliances and paving, $247,800 was for landscaping, $187,620 was for lease up fee and $93,810 for rental guarantee. The remainder, $2,444,437, was for commissions, issue costs, first mortgage arranging, placement fee, structuring, second equity note arranging, buydown and guarantee, and the CMHC fee.
[9] The statement of projected partnership income showed a loss in the period ending December 1993 of $1,174,044 attributed largely to a first year write-off of $1,230,660 for partnership services and a relatively small income because the operation was starting late in the year. After 1993 there was positive income which was reduced to nil by capital cost allowance ("CCA") for 1994, 1995 and in 1996 and thereafter the CCA available was insufficient to reduce the income to nil, and accordingly income was attributed to the partners. After 1993, when there was positive cash flow, there would be cash distributions to the partners although for obvious reasons they would not necessarily correspond to the income of each partner for the purposes of the Income Tax Act.
[10] The first five years had somewhat larger expenses both within the partnership (partnership services) and at the investor level, partner services, which were being amortized over five years.
[11] It is not contended that the price paid for the property, the commissions or the cost of the other services were unreasonable or unduly high. Mr. Thiessen's evidence is that they were normal and this is not contradicted.
[12] As stated in the partial agreed statement of facts, each unit of the limited partnership entitled the unit holder to acquire one apartment in the event of withdrawal from the partnership or the winding up of the partnership. The type and size of apartment depended on whether the unit was type A, B, C, D, or E. Since the acquisition of an apartment by a partner would constitute a disposition of the apartment at fair market value and result in a credit to the pool of undepreciated capital cost, with an ultimate potential at some future date of recapture of CCA, the withdrawing partners were required to pay a specified amount to the partnership to compensate it for the increased recapture it would ultimately have to pay if the building were sold.
[13] Mr. Milewski, as the holder of three partnership units, was entitled to three apartments. Mr. Allen was entitled to two. Neither has ever occupied the apartments nor does either one intend to do so.
[14] I turn now to the question of financing the partnership units. The appellants paid $1,000 down per unit. The balance of the purchase price was provided by a borrowing on "equity notes" in favour of Security Home Mortgage Corporation, guaranteed by CMHC, and secured against the land and buildings and on Second Equity Notes in favour of Chapman Court Limited, the vendor. Chapman Court subsequently offered a 35% reduction for the early repayment of the Second Equity Notes. Mr. Milewski took advantage of the offer, but Mr. Allen did not.
[15] On these facts the Minister denied the deduction in 1993 of the loss of $30,690 allocated to Mr. Milewski from the partnership and the interest of $1,554. In 1994, the Minister denied Mr. Milewski the deduction of interest of $15,812. He had in fact deducted $22,827.20 in interest and $3,819 in partner service charges.
[16] In the case of Mr. Allen who joined the partnership in 1994, he deducted $12,141.42 in interest on the Equity Notes and the Second Equity Notes and $2,596 in partner services. The Minister disallowed only the interest charges of $12,141.42.
[17] Counsel for the respondent suggested that the failure to disallow the partner service charges was probably an oversight.
[18] In my opinion, the respondent has misapplied the NREOP doctrine. We are dealing here with two individuals who have invested, through a limited partnership, in a perfectly viable business that started making a profit in the second year. There was no personal element involved — neither appellant has any intention of residing in the apartments. The form of investment was sensible in that the effect of vacancies did not impact on individual apartment owners but was spread over the partnership as a whole.
[19] The substantial loss in the first year, of which $30,690 was allocated to Mr. Milewski, was simply a one-time write-off of $1,230,660. It is not suggested that the amounts making up that figure are not deductible, or should have been spread over a number of years. It should be noted that the $1,230,660 that was deducted in 1993 was a deduction taken at the level of the partnership and it is admitted that the partnership business was viable, with a reasonable expectation of profit.
[20] How then does the fact that the acquisition of the limited partnership interests was financed substantially by the borrowing of money through the Equity Notes and Second Equity Notes at what, on the evidence, was a favourable interest rate, turn a viable and profitable business into one that had no reasonable expectation of profit and was, therefore, not a business and not a source of income? The investment was clearly long term and bona fide, with the expectation that in the fullness of time the debt would be paid down and ultimately paid off and the appellants would have a lasting investment. The Minister's position, as revealed in the portions of the examination for discovery that were read in, is that once the income from the partnership exceeded the interest charges, the non-business will become a business and the Minister will start to tax.
[21] What troubles the Minister is not the question whether the partnership — and therefore the partners — see The Queen v. Robinson et al., 98 DTC 6065 — are carrying on a business — it is obvious that they are — but rather that the partners' participation is fully financed and, what is worse, fully financed as part of the package.
[22] Whatever else may be said about 99% financing of an investment, it certainly cannot be said that its result is that the vehicle in which the taxpayer has invested did not carry on a business. This is wrong as a matter of logic, law and common sense. The Minister is seeking to limit the deduction of the amount of interest which is permitted by paragraph 20(1)(c) by intoning the ritual incantation NREOP, where it is obvious and admitted that the partnership is carrying on a profitable business.
[23] The Minister has not endeavoured to limit it by the concluding words of paragraph 20(1)(c) ("or a reasonable amount in respect thereof") or section 67. Such an attack would in all probability not have succeeded in any event: Mohammad v. The Queen, 97 DTC 5503; Saunders et al. v. The Queen, 98 DTC 3390.
[24] I do not intend in this judgment to add to the multitude of judicial and academic treatises on the subject of reasonable expectation of profit. There has already been more written than the topic warrants.
[25] The NREOP principle may have some application where a person tries to write off losses from a hobby such as horseracing (Rai v. The Queen, February 8, 1999, file number 98-925(IT)I); or from collecting antique Coca-Cola bottles (Kaye v. The Queen, 98 DTC 1659); or renting a portion of the basement of that person's dwelling to a relative and trying to write off 2/3 of the costs of the house. It operates at the liminal stage of questioning the existence of a business. Where there is no personal element and a genuine business exists the NREOP doctrine has no application. (Tonn et al. v. The Queen, 96 DTC 6001; The Queen v. Gulf Canada Resources Limited, 96 DTC 6065 at 6069; Hickman Motors Limited v. The Queen, 97 DTC 5363 at 5373.
[26] I have concluded that the NREOP doctrine has no application to this obviously viable business. To use it to restrict the deduction of interest that is specifically permitted by paragraph 20(1)(c) ignores not only the plain meaning of that paragraph, but the highest pronouncements as to the purpose of the interest deduction: Tennant v. The Queen, 96 DTC 6121 at 6125 (S.C.C.). If the Government of Canada wishes to limit the extent to which businesses and investments may be financed with borrowed money, the NREOP principle is not the way to do it.
[27] The appeals are allowed with costs and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with these reasons.
Signed at Ottawa, Canada, this 12th day of August 1999.
“D.G.H. Bowman”
J.T.C.C.