Walls v. Canada, [2002] 2 S.C.R. 684, 2002 SCC 47
Her Majesty The Queen Appellant
v.
Jack Walls and Robert Buvyer Respondents
Indexed as: Walls v. Canada
Neutral citation: 2002 SCC 47.
File No.: 27724.
2001: December 12; 2002: May 23.
Present: McLachlin C.J. and L’Heureux‑Dubé, Gonthier, Iacobucci, Major, Bastarache, Binnie, Arbour and LeBel JJ.
on appeal from the federal court of appeal
Income tax – Source of income – Test to determine whether taxpayer has business or property source of income – Whether “reasonable expectation of profit” test appropriate test – Income Tax Act, S.C. 1970-71-72, c. 63, s. 9.
The respondents were limited partners in a partnership. A mini-warehouse was purchased from Fraser Storage Park Ltd. (“FSPL”) on behalf of the partnership for $2,200,000 payable in the form of $1 in cash and the balance in the form of an agreement for sale with interest payable at 24 percent per annum. The partnership also entered into agreements by virtue of which the partnership obligated itself to pay, on an annual basis, interest, service fees, and management fees, as well as 50 percent of the net operating profit of the operation to FSPL. The partnership generated losses on the mini-warehouse of which the respondents deducted their proportionate share for income tax purposes in 1984 and 1985. On reassessment, the Minister of National Revenue reduced the losses by reducing the purchase price of the mini-warehouse to reflect a fair market value of $1,180,000 and also reduced the allowable interest expense by disallowing interest on debt in excess of the fair market value and by lowering the interest rate to 16 percent. The respondents filed notices of objection, but the Minister confirmed the reassessment. The Federal Court, Trial Division dismissed the respondents’ appeals based solely on its finding that the partnership did not carry on business with a reasonable expectation of profit and, therefore, that the losses from the storage park operation were not losses from a business and thus could not be deducted by the respondents. The Federal Court of Appeal set aside the judgment, holding that the trial judge erred in applying the reasonable expectation of profit doctrine, and remitted the matter to the trial judge for a determination of the outstanding issues of whether there had been an arm’s length transaction and its fair market value. The only issue in this appeal is whether the storage park operation constituted a source of income for the purposes of s. 9 of the Income Tax Act.
Held: The appeal should be dismissed.
When the two-stage approach and the principles set out in the companion case Stewart v. Canada, [2002] 2 S.C.R. 645, 2002 SCC 46, are applied, it is clear that the respondents’ storage park operation constituted a source of income for the purposes of s. 9 of the Income Tax Act. It is self-evident that such an activity is commercial in nature, and there was no evidence of any element of personal use or benefit in the operation. Where, as here, the activities have no personal aspect, reasonable expectation of profit does not arise for consideration. Although the respondents were clearly motivated by tax considerations when they purchased their interests in the partnership, this does not detract from the commercial nature of the storage park operation or its characterization as a source of income. A tax motivation does not affect the validity of transactions for tax purposes. In addition, given the specific anti-avoidance provisions in the Act, courts should not be quick to embellish its provisions in response to tax avoidance concerns.
Cases Cited
Followed: Stewart v. Canada, [2002] 2 S.C.R. 645, 2002 SCC 46; restricted: Moldowan v. The Queen, [1978] 1 S.C.R. 480; distinguished: Moloney v. The Queen, 92 D.T.C. 6570; referred to: Tonn v. Canada, [1996] 2 F.C. 73; Mastri v. Canada (Attorney General), [1998] 1 F.C. 66; Backman v. Canada, [2001] 1 S.C.R. 367, 2001 SCC 10; Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622; Canada v. Antosko, [1994] 2 S.C.R. 312; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; Ludco Enterprises Ltd. v. Canada, [2001] 2 S.C.R. 1082, 2001 SCC 62; Neuman v. M.N.R., [1998] 1 S.C.R. 770.
Statutes and Regulations Cited
Income Tax Act, S.C. 1970-71-72, c. 63 [now R.S.C. 1985, c. 1 (5th Supp.)], ss. 9, 18(1)(a), 20(1)(c), 67, 172(2), 251.
APPEAL from a judgment of the Federal Court of Appeal (1999), 250 N.R. 324, 2000 D.T.C. 6025, [2000] 1 C.T.C. 324, [1999] F.C.J. No. 1823 (QL), reversing a decision of the Trial Division (1996), 107 F.T.R. 108, 96 D.T.C. 6142, [1996] 2 C.T.C. 14, [1996] F.C.J. No. 145 (QL). Appeal dismissed.
Brent Paris and Richard Gobeil, for the appellant.
Craig C. Sturrock and Thomas M. Boddez, for the respondents.
The judgment of the Court was delivered by
Iacobucci and Bastarache JJ.--
I. Introduction
1 This appeal raises substantially similar issues to those considered by the Court in Stewart v. Canada, [2002] 2 S.C.R. 645, 2002 SCC 46, the decision and reasons in which are being released herewith. Consequently, the reasoning set out by the Court in that case is applicable to this appeal. As in Stewart, we conclude here that the taxpayers’ activities constituted a source of income for the purposes of s. 9 of the Income Tax Act, S.C. 1970-71-72, c. 63 (the “Act”). Accordingly, we agree with the disposition of the Federal Court of Appeal and would therefore dismiss the appeal.
II. Facts
2 In July 1983 Fraser Storage Park Ltd. (“FSPL”) was incorporated under the laws of British Columbia. One third of its issued shares were owned by Victor Bolton through a holding company. One quarter of its issued shares were owned by Raymond Matty, also through holding companies.
3 In the fall of 1983, FSPL, represented by Raymond Matty and Victor Bolton, arranged to purchase a mini-warehouse from Twin Builders Ltd. for $1,180,000. In October, Fraser Storage Park Partnership (the “Partnership”) was founded, with Brem Management Ltd. as the general partner and Matty Developments Ltd. as the founding partner. Raymond Matty and Victor Bolton each owned 50 percent of the shares of Brem Management Ltd., and Raymond Matty owned all of Matty Developments Ltd. In October, FSPL entered into an interim agreement to sell the mini-warehouse to Brem Management Ltd. on behalf of the Partnership for $2,200,000, payable in the form of $1 in cash and the balance in the form of an agreement for sale with interest payable to FSPL at 24 percent per annum. Raymond Matty and Victor Bolton negotiated the purchase and sale of the mini-warehouse on behalf of both FSPL and the Partnership. The transfer of the mini-warehouse from Twin Builders Ltd. to FSPL and the agreement for sale between FSPL and Brem Management Ltd. on behalf of the Partnership were all registered on December 30, 1983.
4 In addition to entering into the agreement for sale, the Partnership also entered into a management agreement and a services agreement with FSPL. By virtue of these agreements and the agreement for sale, the Partnership obligated itself to pay, on an annual basis, $528,000 in interest, $140,000 in service fees, and $50,000 in management fees, as well as 50 percent of the net operating profit of the operation.
5 The respondents, Jack Walls and Robert Buvyer, were limited partners in the Partnership. The Partnership generated losses on the mini-warehouse, which were allocated to the respondents and the other partners on a prorated basis. The respondents deducted their proportionate share of the losses for income tax purposes. The respondents were reassessed by the Minister of National Revenue for their 1984 and 1985 taxation years on the losses claimed by virtue of their being partners in the Partnership. The Minister reduced the losses by reducing the purchase price of the mini-warehouse to reflect a fair market value of $1,180,000, rather than the $2,200,000 paid by the Partnership. The Minister also reduced the allowable interest expense by disallowing interest on debt in excess of $1,180,000, and by lowering the interest rate from 24 percent to 16 percent on the basis that 24 percent was excessive. The respondents filed notices of objection, but the Minister confirmed the notices of reassessment. The respondents appealed, and the two appeals by each of the two respondents were heard together.
6 The respondents claimed that, owing to the depressed real estate market at the time, it was impossible to obtain conventional financing with respect to such projects without providing substantial equity in the project and full recourse financing. They argued that, given the terms of the agreement, and since FSPL and the Partnership were at arm’s length, the interest expense was reasonable as required under s. 20(1)(c) and s. 67 of the Act. The respondents also argued that $2,200,000 was the fair market value of the property at the material time.
7 The Minister argued that the Partnership did not carry on business with a reasonable expectation of profit such that the losses from the storage park operation were not losses from a business and thus could not be deducted under s. 18(1)(a) of the Act by the partners. In the alternative, the Minister asserted that the amount of interest claimed by the Partnership was unreasonable pursuant to s. 20(1)(c) and s. 67 of the Act, that the fair market value of the mini-warehouse had been $1,180,000, and that Brem Management Ltd. and the Partnership were not dealing at arm’s length with FSPL pursuant to s. 251 of the Act.
8 The Federal Court, Trial Division, dismissed the appeals based solely on its finding that the Partnership did not carry on business with a reasonable expectation of profit and, therefore, that the losses from the storage park operation were not losses from a business and thus could not be deducted by the respondents. The Federal Court of Appeal allowed the appeals, set aside the lower court judgments, and remitted the matter to the trial judge for a determination of the two outstanding issues of whether there had been an arm’s length transaction and its fair market value.
III. Relevant Statutory Provisions
9 Income Tax Act, S.C. 1970-71-72, c. 63 (now R.S.C. 1985, c. 1 (5th Supp.))
9. (1) Subject to this Part, a taxpayer’s income for a taxation year from a business or property is his profit therefrom for the year.
18. (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of
(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;
20. (1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:
. . .
(c) an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on
(i) borrowed money used for the purpose of earning income from a business or property . . .
or a reasonable amount in respect thereof, whichever is the lesser;
67. In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.
251. (1) For the purposes of this Act,
(a) related persons shall be deemed not to deal with each other at arm’s length; and
(b) it is a question of fact whether persons not related to each other were at a particular time dealing with each other at arm’s length.
IV. Judgments Below
A. Federal Court, Trial Division (1996), 107 F.T.R. 108
10 Each of the two respondents brought appeals before the Federal Court, Trial Division, pursuant to s. 172(2) of the Income Tax Act with respect to the Minister’s reassessments for the 1984 and 1985 taxation years. Pursuant to the order of Pinard J. dated August 17, 1995, all four appeals were heard together on the same evidence.
11 Pinard J. began his assessment of the reasonable expectation of profit of the Partnership by referring to the following passage from the pivotal case of Moldowan v. The Queen, [1978] 1 S.C.R. 480, at pp. 485-86:
There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer’s training, the taxpayer’s intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive. The factors will differ with the nature and extent of the undertaking: The Queen v. Matthews [(1974), 74 D.T.C. 6193]. One would not expect a farmer who purchased a productive going operation to suffer the same start-up losses as the man who begins a tree farm on raw land.
12 In applying the criteria laid out in Moldowan to the facts before him, Pinard J. found that the profit and loss experience was not particularly helpful in this case, given the enormous increase in the expenses of the storage park resulting from the agreement for sale, service agreement and management agreement, none of which existed prior to 1983. He considered the key factor to be the capability of the venture as capitalized to show a profit after charging capital cost allowance. Examining the financial state of the operation in considerable detail, Pinard J. concluded at para. 15 that:
As things stood, the Partnership was unable to make a profit because it was effectively under capitalized. No plan existed to raise additional capital to reduce the debts of the Partnership. The inability of the venture as capitalized to show a profit, even before taking capital cost allowance, is a clear indication that the Partnership did not have a reasonable expectation of profit.
13 With respect to the other Moldowan factors, Pinard J. noted that none of the partners had any previous experience running a storage park. As well, no details had been provided on how to achieve the stated intended course of action of increasing the occupancy of the storage park and increasing the income in order to realize its inherent value. Finally, he found no basis for claiming that the losses related to a start-up period, since the storage park was purchased as a “going operation”.
14 Pinard J. concluded that on the facts before him, the Partnership did not carry on business with a reasonable expectation of profit. In his view, at paras. 17 and 19:
. . . [the Partnership] was set up as a tax shelter, with the intention that the operation of the storage park would give rise to large initial losses in order to provide the limited partners with tax claims. . . .
. . .
The evidence in this case indicates that the only financial advantage that could reasonably have been expected by a purchaser of a limited partnership unit in this arrangement would have been by way of tax refunds as a result of claiming the inevitable losses from the arrangement. . . .
15 As a result, Pinard J. found that the losses sustained were not losses from business and could not be deducted by the respondents to the extent of their proportionate interests. The appeals were therefore dismissed.
B. Federal Court of Appeal, [2000] 1 C.T.C. 324
16 Robertson J.A., for the court, stated that, based on the facts of the case and the Federal Court of Appeal’s previous decisions in Tonn v. Canada, [1996] 2 F.C. 73, and Mastri v. Canada (Attorney General), [1998] 1 F.C. 66, the trial judge had erred in applying the reasonable expectation of profit doctrine set out by the Supreme Court of Canada in Moldowan, supra. He continued at para. 1:
For example, there is no “personal element” involved in the series of transactions under review. The [respondents] were limited partners who purchased an ongoing commercial business. The fact that the purchase was driven, in part, by favourable tax considerations does not detract from the ongoing commercial nature of the endeavour.
17 Robertson J.A. therefore allowed the appeals, set aside the lower court judgments, and remitted the matter to the trial judge for a determination of the two outstanding issues of whether there was an arm’s length transaction and its fair market value.
V. Issue
18 Did the storage park operation constitute a source of income for the purposes of s. 9 of the Act?
VI. Analysis
19 The test to determine whether a taxpayer’s activities constitute a source of business or property income for the purposes of s. 9 of the Act is set out in Stewart, supra, at para. 50 as follows:
(i) Is the activity of the taxpayer undertaken in pursuit of profit, or is it a personal endeavour?
(ii) If it is not a personal endeavour, is the source of the income a business or property?
In addition, at para. 53 of that case, we emphasized that the first stage of this test will only be relevant when there is some personal or hobby element to the activity in question. Where an activity is clearly commercial, the taxpayer is necessarily engaged in the pursuit of profit, and therefore a source of income exists.
20 Applying these principles to this case, we find that it is clear that the storage park operation constituted a source of income for the purposes of s. 9 of the Act. It is self-evident that such an activity is commercial in nature, and there was no evidence of any element of personal use or benefit in the operation. Although we state in Stewart, supra, at para. 55, that reasonable expectation of profit may be used as one factor in making the overall determination as to whether or not the taxpayer’s activities are personal or commercial, where, as here, the activities have no personal aspect, reasonable expectation of profit does not arise for consideration.
21 The trial judge referred to the storage park operation as a “tax shelter” and concluded that the reduction of tax was the sole motivation for its existence, citing Moloney v. The Queen, 92 D.T.C. 6570 (F.C.A.). However, in that case, a circular scheme was set up for the sole purpose of obtaining tax refunds with no intention on the part of the taxpayer to carry on the business of marketing a speed reading course which was the ostensible purpose of the transactions. It was in this context that Hugessen J.A. stated, at p. 6570:
While it is trite law that a taxpayer may so arrange his business as to attract the least possible tax, it is equally clear in our view that the reduction of his own tax cannot by itself be a taxpayer’s business for the purpose of the Income Tax Act. [Emphasis added.]
With respect, the case at bar is distinguishable from Moloney. There, the taxpayer was not engaged in a commercial activity, but instead was involved in a sham set up to appear as though it was commercial in nature where in fact the only activity actually engaged in was that of obtaining tax refunds. Here, in contrast, the Partnership purchased and maintained an ongoing commercial operation.
22 Although the respondents in this case were clearly motivated by tax considerations when they purchased their interests in the Partnership, this does not detract from the commercial nature of the storage park operation or its characterization as a source of income for the purposes of s. 9 of the Act. It is a well-established proposition that a tax motivation does not affect the validity of transactions for tax purposes: Backman v. Canada, [2001] 1 S.C.R. 367, 2001 SCC 10, at para. 22; Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622; Canada v. Antosko, [1994] 2 S.C.R. 312; Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536, at p. 540. In addition, we reiterate the caution stated in Stewart, at para. 65 that, given the specific anti-avoidance provisions in the Act, courts should not be quick to embellish its provisions in response to tax avoidance concerns: see also Ludco Enterprises Ltd. v. Canada, [2001] 2 S.C.R. 1082, 2001 SCC 62, at para. 39; Neuman v. M.N.R., [1998] 1 S.C.R. 770, at para. 63.
VII. Conclusion
23 For these reasons, we conclude that the storage park operation carried on by the Partnership, in which the respondents were limited partners, constituted a source of income for the purposes of s. 9 of the Act. As a result, we would dismiss the appeal with costs.
Appeal dismissed with costs.
Solicitor for the appellant: The Deputy Attorney General of Canada, Vancouver.
Solicitors for the respondents: Thorsteinssons, Vancouver.