A-650-96
The Attorney General of Canada (Applicant)
v.
June Mastri (Respondent)
A-651-96
The Attorney General of Canada (Applicant)
v.
Michael Mastri (Respondent)
Indexed as: Mastriv. Canada (Attorney General) (C.A.)
Court of Appeal, MacGuigan, Robertson and McDonald JJ.A."Toronto, June 12; Ottawa, June 27, 1997.
Income tax — Income calculation — Deductions — Judicial review of T.C.C. decision taxpayers entitled to deduct share of rental loss incurred on property purchased as principal residence from other income — Holding reasonable expectation of profit, but M.N.R. not establishing —personal element— or —foreseeable tax advantage— accruing to taxpayers during taxation year as required by Tonn v. Canada — T.C.C. erred in understanding, application of Tonn — Tonn not altering law as stated in Moldowan v. The Queen: (1) to have source of income, taxpayer must have reasonable expectation of profit; (2) whether reasonable expectation of profit objective determination — Tonn affirming courts not to second guess business decisions of taxpayers — —Personal element— existing as property purchased as principal residence; no evidence considering whether could be rented profitably.
Judges and Courts — Judicial review of T.C.C. decision taxpayer entitled to deduct share of rental loss on property purchased as principal residence from other income — Relying on Tonn v. Canada — M.N.R. submitting Tonn should be overruled as wrongly decided — Incorrect to speak of recent F.C.A. panel overruling earlier one — Rule of stare decisis dictates both decisions of equal weight — Formal means for overruling earlier decision to strike enlarged F.C.A. panel where conflicting decisions, lines of authority on issue of fundamental significance to area of federal law.
These were applications for judicial review of the Tax Court's decision that the taxpayers were entitled to deduct their share of rental loss from other income in their 1991 income tax returns. The taxpayers had purchased a townhouse in December 1990, intending to use it as their principal residence. When Mr. Mastri was transferred to another city, the couple rented the property until the end of November 1991. The taxpayers received $12,375 as rent during 1991 and claimed $27,730.97 in expenses. Each taxpayer claimed one-half of the rental loss of $15,355.97. The Tax Court concluded that there was no reasonable expectation of profit for 1991, but that applying Tonn v. Canada it was incumbent on the Minister to establish that there was either a "personal element" or a "foreseeable tax advantage" accruing to the taxpayers during the taxation year. The Tax Court held that the Minister had not demonstrated that either of these factors were present. The Minister submitted that Tonn should be overruled as wrongly decided.
Held, the applications should be allowed.
Although a decision of one panel of the Federal Court of Appeal is not binding on another, it is incorrect to speak of a recent decision overruling an earlier one. Both decisions are of equal weight. The formal means for overruling an earlier decision is to have the Court strike an enlarged panel, as may be done where there are two conflicting decisions or lines of authority, and the issue is of fundamental significance in an area of federal law.
Tonn was correctly decided. Moldowan decided: (1) that in order to have a source of income a taxpayer must have a reasonable expectation of profit; and (2) "whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts". If, as a matter of fact, a taxpayer is found not to have a reasonable expectation of profit then there is no source of income and, therefore, no basis upon which the taxpayer is able to calculate a rental loss. This Court has followed and applied Moldowan.
Tonn did not intend to establish a rule of law to the effect that even though there is no reasonable expectation of profit, losses are deductible from other income sources unless, for example, the income earning activity involved a personal element. The reference in Tonn to the Moldowan test being applied sparingly was intended as a common sense guideline for the Tax Court. "Sparingly" was meant to convey the understanding that in cases where, for example, there is no personal element, the judge should apply the reasonable expectation of profit test less assiduously than if such a factor were present. The Court in Tonn was simply cautioning against second-guessing the business decisions of taxpayers. Tonn did not purport to alter the law as stated in Moldowan. Accordingly, the Tax Court Judge erred in his understanding and application of Tonn.
Finally, a "personal element" did exist herein. The taxpayers bought the townhouse intending to occupy it themselves, and roughly a year after purchase actually used it as their principal residence. There was no evidence that at the time of purchase, consideration was given to whether the townhouse could be rented profitably.
statutes and regulations judicially considered
Income Tax Act, R.S.C., 1985 (5th Supp.), c. 1, ss. 18(1)(b),(h), 67, 248(1) "personal or living expenses".
cases judicially considered
applied:
Tonn v. Canada, [1996] 2 F.C. 73; (1995), 96 DTC 6001; 191 N.R. 182 (C.A.); Moldowan v. The Queen, [1978] 1 S.C.R. 480; (1977), 77 D.L.R. (3d) 112; [1977] CTC 310; 77 DTC 5213; 15 N.R. 476.
overruled:
Howard v. Canada, [1997] T.C.J. No. 69 (QL); Rossi v. Canada, [1996] T.C.J. No. 1632 (QL).
referred to:
Canada v. Aqua-Gem Investments Ltd., [1993] 2 F.C. 425; [1993] 1 C.T.C. 186; (1993), 93 DTC 5080; 149 N.R. 273 (C.A.); Landry (C.) v. Canada, [1995] 2 C.T.C. 3; (1994), 94 DTC 6624 (F.C.A.); Poetker v. Minister of National Revenue, [1996] 1 C.T.C. 202; (1995), 95 DTC 5614 (F.C.A.); Hugill (R.) v. Canada, [1995] 2 C.T.C. 16; (1995), 95 DTC 5311 (F.C.A.); Joudrey v. Canada, [1997] T.C.J. No. 74 (QL); Stacey v. Canada, [1997] T.C.J. No. 117 (QL); Riddell, M.L. v. The Queen (1996), 97 DTC 51 (T.C.C.); Schimmens v. Canada, [1996] T.C.J. No. 539 (QL); Urquhart v. R., [1997] 1 C.T.C. 2611 (T.C.C.); Wallace v. Canada, [1996] T.C.J. No. 583 (QL).
authors cited
Silver, S. "Great Expectations: Are They Reasonable?" in Real Estate Transactions: Tax Planning for the Second Half of the 1990s . 1995 Corporate Management Tax Conference. Toronto: Canadian Tax Foundation, 1996.
APPLICATIONS for judicial review of the Tax Court's decision that the taxpayers were entitled to deduct their share of rental loss incurred on a property purchased as a principal residence from other income in their 1991 income tax returns (Mastri v. R., [1996] 3 C.T.C. 2702 (T.C.C.)). Applications allowed.
counsel:
Jagmohan S. Gill and Carol Shirtliff-Hinds for applicant.
John R. Owen and Douglas H. Mathew for respondents.
solicitors:
Deputy Attorney General of Canada for applicant.
Thorsteinssons, Toronto, for respondents.
The following are the reasons for judgment rendered in English by
Robertson J.A.: These applications for judicial review stem from a decision of the Tax Court of Canada [Mastri v. R., [1996] 3 C.T.C. 2702] allowing the appeals of the respondent taxpayers, June Mastri and her husband Michael, which appeals were heard on common evidence in respect of reassessments issued for the 1991 taxation year. The principal issue is whether each of the taxpayers is entitled to deduct their proportionate share of rental losses from other sources of income pursuant to the provisions of the Income Tax Act [R.S.C., 1985 (5th Supp.), c. 1] (the Act). Applying the decision of this Court in Tonn v. Canada, [1996] 2 F.C. 73 (C.A.), the Tax Court Judge reached a positive conclusion even though he found that there was "no reasonable expectation of profit" on the part of the taxpayers. The Minister of National Revenue takes the rather bold position that Tonn was wrongly decided and urges this differently constituted panel of the Court to "overrule" the earlier precedent or at the very least "clarify" what was decided in Tonn . While I am prepared to acknowledge that some confusion has arisen in the Tax Court as to what was actually decided by Tonn, the fact remains that there is no basis in law or theory for departing from the true import of that decision. In my respectful view, the learned Tax Court Judge misapprehended its meaning, as has the Minister and counsel for the taxpayers.
The essential facts are relatively straightforward. In August of 1990 the taxpayers entered into an agreement to purchase a three-bedroom condominium townhouse in Oakville for $159,000. The sale was completed in December of that year after the purchasers obtained a mortgage loan of $117,000. The taxpayers also received the proceeds of a $45,000 loan which was secured by a mortgage on the home of June Mastri's parents. At the time the agreement of purchase and sale was signed, it was the taxpayers' intention to use the property as their principal residence. But in late 1990 Michael was transferred by his employer from Burlington to Toronto, at which time the Mastris decided to rent the property. During the 1991 taxation year the property was rented until the end of November. Subsequent attempts to rent the property proved futile. As property values were on the decline, the taxpayers decided against selling the property and instead made it their principal residence. Rent received during the 1991 taxation year totalled $12,375 with the taxpayers claiming $27,730.97 in expenses. Of the latter amount, $15,675.73 (that is 57%) related to interest. Each taxpayer claimed one-half of the rental loss of $15,355.97.
Following a lengthy and painstaking review of the evidence, the Tax Court Judge concluded that there was no reasonable expectation of profit for the 1991 taxation year. This finding of fact has not been assailed by any of the parties and, in my opinion, rightly so. The sole rationale for the taxpayers' claim of a loss in 1991 was that they had calculated that there would be a profit in 1992. Notwithstanding the finding of lack of reasonable expectation of profit, the Tax Court Judge went on to hold that that finding was not determinative of the issue at hand. According to his understanding of the reasoning in Tonn, it was incumbent on the Minister to establish also that there was either a "personal element" or "foreseeable tax advantage" accruing to the taxpayers during the taxation year in question. In the opinion of the Tax Court Judge, the Minister had failed to demonstrate that either of these factors was present. Accordingly, he held that the taxpayers were entitled to deduct their share of the rental loss from other income. Having so concluded, the Tax Court Judge considered the further issue of the application of section 67 and paragraph 18(1)(b ) of the Act to limit certain expenses deducted by the taxpayers which he found to be of a capital nature. The taxpayers conceded that approximately $3,000 was on account of capital and not deductible as a current expense. The Tax Court Judge went on to find that a greater amount should be allocated to capital and ultimately concluded that the rental loss was $8,958 and not $15,356 as originally claimed. In short, total expenses were reduced to $21,333 of which $15,675 (or 73%) was attributable to interest.
The thrust of the Minister's argument is that in Tonn this Court departed from its earlier decisions to establish the principle that the reasonable expectation of profit test, established in Moldowan v. The Queen, [1978] 1 S.C.R. 480, is applicable only where it can be shown that the facts reveal an "inappropriate reduction in tax", the presence of a "personal benefit" or "where the expectation of profit was so unreasonable as to raise a suspicion". Thus, the Moldowan test remains irrelevant until such time as one of these factors can be established. The taxpayers, too, contend that in circumstances where a taxpayer's motives are solely commercial in nature, Tonn dictates that the reasonable expectation of profit test would not normally be applied.
Returning to the Minister's submissions, it is further argued that the Court in Tonn fell into error by confusing the issue of deductibility of an expense with the deductibility of a rental loss (loss from a property) from a taxpayer's other sources of income (e.g. employment income). It is on this basis that the Minister urges us to "overrule" Tonn , a case decided by a unanimous panel of this Court in December of 1995.
It is important to recognize that although a decision of one panel of this Court is not binding on another, it is incorrect to speak of a recent decision overruling an earlier one. The accepted rules of stare decisis dictate that both decisions are of equal weight. It is true that with the passage of time an earlier decision may fall into disfavour and, thus, lose its persuasiveness through application of various well-known judicial techniques. It is equally true that on occasion one panel expressly disapproves of an earlier decision where the principal author of that decision or the majority of that panel is now sitting on the subsequent case. More often than not the earlier decision was rendered from the bench or was decided per incuriam. Aside from these circumstances, the formal means for overruling an earlier decision is to have the Court strike an enlarged panel, as may be done where there are two conflicting decisions of the Court, or conflicting lines of authority, and the issue involved is deemed to be of fundamental significance to the jurisprudence in a particular area of federal law: see Canada v. Aqua-Gem Investments Ltd., [1993] 2 F.C. 425 (C.A.). All that being said, I have no doubt that Tonn was correctly decided. There is no question, however, that it has caused some difficulty in interpretation and application for certain judges of the Tax Court, which difficulty stems in part from perceived ambiguities in the language used in Tonn.
I do not propose to deal with the Minister's argument in detail for the reason that it is devoid of merit. There is no basis for postulating that the Court in Tonn confused the concept of deductibility of an expense with the concept of deductibility of rental losses from income derived from other sources. Admittedly, there are oblique references to the reasonable expectation of profit test established in Moldowan being used to disallow the deduction of personal expenses rather than business or property losses: see Tonn, supra, at pages 90-91 and 95. These references arose in the context of an analysis seeking to show the origin of the reasonable expectation of profit test which can be traced to the prohibition against deduction of "personal or living expenses" under paragraph 18(1)(h ), which term is defined in subsection 248(1). I cannot help but acknowledge that even tax commentators have succumbed to the same slip of the pen: see S. Silver, "Great Expectations: Are They Reasonable?" in 1995 Corporate Management Tax Conference, Real Estate Transactions: Tax Planning for the Second Half of the 1990s (Toronto: Canadian Tax Foundation, 1996) 6:1, at pages 6:15-6:16, quoted in Tonn, at pages 93-94. In the end, however, it is readily apparent that the Court in Tonn recognized that the issue before it was whether the rental losses could be deducted from other sources of income: see Tonn, supra, at pages 79 and 83.
For the sake of doctrinal purity, I should also point out that a distinction must be drawn between the determination of whether a taxpayer's source of income is from a business as opposed to a property. I may own a rental property but whether I carry on a business in regard thereto is a distinct legal issue giving rise to other tax consequences not relevant to the cases under review. Thus, strictly speaking it is inappropriate to speak of business expenses incurred in relation to a rental property unless, of course, the taxpayer's endeavours are regarded in law as a business. In any event, it is helpful at this point to set out the specific findings of law articulated in Moldowan.
First, it was decided in Moldowan that in order to have a source of income a taxpayer must have a reasonable expectation of profit. Second, "whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts" (supra , at pages 485-486). If as a matter of fact a taxpayer is found not to have a reasonable expectation of profit then there is no source of income and, therefore, no basis upon which the taxpayer is able to calculate a rental loss. There is no doubt that, post-Moldowan, this Court has followed and applied that decision: see Landry (C.) v. Canada, [1995] 2 C.T.C. 3 (F.C.A.); Poetker v. Minister of National Revenue, [1996] 1 C.T.C. 202 (F.C.A.); and Hugill (R.) v. Canada, [1995] 2 C.T.C. 16 (F.C.A.). The only remaining issue is whether Tonn departs from that jurisprudence by postulating that the reasonable expectation of profit test remains irrelevant to the question of deductibility of losses until such time as it can be established that the case involves an inappropriate deduction of tax, the presence of a strong personal element or suspicious circumstances. There are two passages in Tonn which are cited in support of that proposition of law and are worthy of reproduction (supra, at page 96 and at pages 103-104):
The Moldowan test, therefore is a useful tool by which the tax-inappropriateness of an activity may be reasonably inferred when other, more direct forms of evidence are lacking. Consequently, when the circumstances do not admit of any suspicion that a business loss was made for a personal or non-business motive, the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgment may have been less than competent.
. . .
. . . I otherwise agree that the Moldowan test should be applied sparingly where a taxpayer's "business judgment" is involved, where no personal element is in evidence, and where the extent of the deductions claimed are not on their face questionable. However, where circumstances suggest that a personal or other-than-business motivation existed, or where the expectation of profit was so unreasonable as to raise a suspicion, the taxpayer will be called upon to justify objectively that the operation was in fact a business. Suspicious circumstances, therefore, will more often lead to closer scrutiny than those that are in no way suspect.
In my respectful view, neither of the above passages support the legal proposition espoused by both the Minister and the taxpayers. It is simply unreasonable to posit that the Court intended to establish a rule of law to the effect that, even though there was no reasonable expectation of profit, losses are deductible from other income sources unless, for example, the income earning activity involved a personal element. The reference to the Moldowan test being applied "sparingly" is not intended as a rule of law, but as a common-sense guideline for the judges of the Tax Court. In other words, the term "sparingly" was meant to convey the understanding that in cases, for example, where there is no personal element the judge should apply the reasonable expectation of profit test less assiduously than he or she might do if such a factor were present. It is in this sense that the Court in Tonn cautioned against "second-guessing" the business decisions of taxpayers. Lest there be any doubt on this point, one need go no further than the analysis pursued by the Court in Tonn .
In Tonn, the Court clearly held that no personal advantage had accrued to the taxpayer who was seeking to deduct rental losses from his other sources of income. Nonetheless, the Court continued to pursue the deductibility of losses issue by applying the factors set out in Moldowan when assessing whether there was a reasonable expectation of profit. The Court's summary, provided at page 109, lays to rest any doubt as to what was decided in Tonn:
My disposition of this case is therefore as follows. The Tax Court Judge erred in principle as well as in his application of the reasonable expectation of profit test, as it is now understood. He did not consider all of the factors he should have considered, nor did he assess the context fully. The evidence clearly showed that the taxpayers engaged themselves in a business enterprise and their expectations of profit were not unreasonable in the circumstances. A small rental business was launched without the aid of sophisticated market analysis at a time when the rental market looked promising. Soon after, as a result of unforeseen circumstances, it became precarious. No personal benefit accrued to the taxpayers by the rental arrangements. The property was not a vacation site. The house was not used to give free or subsidized housing to relatives or friends. They made an honest error in judgment and lost money instead of earning it. It is not for the Department (or the Court) to penalize them for this, using the reasonable expectation of the profit test, without giving the enterprise a reasonable length of time to prove itself capable of yielding profits.
In summary, the decision of this Court in Tonn does not purport to alter the law as stated in Moldowan. Tonn simply affirms the common-sense understanding that it is not the place of the courts to second-guess the business acumen of a taxpayer whose commercial venture turns out to be less profitable than anticipated. Accordingly, the Tax Court Judge erred in his understanding and application of Tonn. The same holds true in regard to the following Tax Court cases which reveal a misunderstanding of the true import of Tonn: Howard v. Canada, [1997] T.C.J. No. 69 (QL); and Rossi v. Canada, [1996] T.C.J. No. 1632 (QL). By comparison, other Tax Court cases confirm my opinion as to what was decided in Tonn: see Joudrey v. Canada, [1997] T.C.J. No. 74 (QL); Stacey v. Canada, [1997] T.C.J. No. 117 (QL); Riddell, M.L. v. The Queen (1996), 97 DTC 51 (T.C.C.); Schimmens v. Canada, [1996] T.C.J. No. 539 (QL); Urquhart v. R., [1997] 1 C.T.C. 2611 (T.C.C.); and Wallace v. Canada, [1996] T.C.J. No. 583 (QL).
Before concluding, I wish to register my respectful disagreement with the finding made below that no "personal element" exists in the circumstances of this case. On the contrary, the evidence clearly shows that the Mastris entered into an agreement to buy the townhouse with the intention of occupying it themselves and that, roughly a year after purchase, they actually used the home as their principal residence. In my opinion, one can scarcely speak of the absence of a personal element in this situation" particularly since there is no evidence indicating that, at the time the taxpayers agreed to purchase the property for $159,000, consideration was given to whether the townhouse could be rented profitably.
The Tax Court Judge having erred in his application of Tonn, and in light of the fact that his finding of lack of reasonable expectation of profit has not been challenged, the taxpayers are not entitled to deduct their respective shares of the rental loss from other income sources. The applications for judicial review should be allowed, the judgments of the Tax Court set aside and the matter remitted for redetermination on the basis that the taxpayers' appeals to that Court be dismissed. The taxpayers are entitled to one set of reasonable and proper costs for both judicial review applications.
MacGuigan J.A.: I agree.
McDonald J.A.: I agree.