A-652-96
Zahid Mohammad (Applicant)
v.
Her Majesty the Queen (Respondent)
Indexed as: Mohammadv. Canada (C.A.)
Court of Appeal, MacGuigan, Robertson and McDonald JJ.A.—Toronto, June 11; Ottawa, July 28, 1997.
Income tax — Income calculation — Deductions — Judicial review of T.C.C. decision reducing amount of deductible interest under Income Tax Act, s. 67 — Taxpayer co-purchasing residential property for rental purposes, intending to realize capital gain — Purchasers assuming existing mortgage, each contributing $25,000 which taxpayer borrowing — Act, s. 67 requiring deductible outlay, expense to be reasonable — M.N.R. disallowing deduction of rental losses on grounds no reasonable expectation of profit — T.C.J. holding unreasonable to finance 100% of purchase price, therefore interest paid on $25,000 not deductible — Judicial doctrine of reasonable expectation of profit, concept of reasonable expenses under s. 67 must be invoked, applied independently — S. 67 must not be used in arbitrary manner, to soften strictures of reasonable expectation of profit test — Must be applied as objectively as possible — Full financing neither bar to deducting rental loss nor ground for reducing amount of interest deductible — Reasonableness of otherwise deductible expense not assessed by reference to whether any one expense, or collective expenses, disproportionate to revenues — Ramsay v. M.N.R., Elliott v. M.N.R. line of cases no longer good law — Refusal to permit deduction of interest on personal loan arbitrary because no principled basis on which to determine amount by which interest expense must be reduced — T.C.C. misinterpreting, misapplying s. 67.
This was an application for judicial review of the Tax Court's decision reducing the amount of deductible interest under Income Tax Act, section 67. In 1987, the applicant taxpayer co-purchased a residential property, intending to rent it for a few years, and then dispose of it, thereby realizing a capital gain. The purchasers assumed an existing mortgage and each contributed a further $25,000 which the taxpayer raised by obtaining a personal bank loan. During the years in question, the property was rented at market rate. For 1989, 1990 and 1991 the taxpayer's share of the rental losses was $7,000, $9,000 and $8,000 respectively. For 1992 and 1993, the losses diminished to $4,000 and $1,000. By 1994, the taxpayer reported a profit of $760. Section 67 provides that an outlay or expense must be reasonable in the circumstances in order to be deductible. The Minister of National Revenue disallowed the deduction of rental losses from employment income on the ground that there was no reasonable expectation of profit. The Tax Court held that the rental venture had a reasonable expectation of profit but that it was unreasonable for the taxpayer to have financed the full purchase price of the property and then to have deducted all of the interest expense.
The issue was whether the Tax Court erred in refusing to permit the deduction of interest paid on the $25,000 personal loan.
Held, the application should be allowed.
Taxpayers frequently acquire a residential property for rental purposes by financing the entire purchase price. The amount of yearly interest payable on the loan often greatly exceeds the rental income that might reasonably have been earned. There can be no reasonable expectation of profit so long as no significant payments are made against the principal amount of the indebtedness. A rental loss can be claimed even though no such payment(s) were made in the taxation years under review, if the taxpayer establishes to the Court's satisfaction that he had a realistic plan to reduce the principal amount of the borrowed monies. The taxpayer will discharge that burden by showing that significant payments were made against the principal indebtedness in the taxation years closely following the year of purchase. The application record referred to such payments having been made, but evidence thereof was not before the Tax Court Judge and was not raised during this hearing.
Section 67 does not deal with the issue of deductibility. In the case of interest payments, deductibility hinges on paragraph 20(1)(c) and satisfaction of the direct-use rule articulated in Bronfman Trust. Since the property was not used by the taxpayer as a personal residence, and as the Tax Court Judge was satisfied that the arrangement between the taxpayer and the other co-owner was carried out by two unrelated persons on commercially acceptable terms, the issue of deductibility per se did not arise.
The Minister relied upon a line of cases, beginning with Ramsay v. M.N.R., which reduced a taxpayer's business expenditures on the ground that the total expenses were excessive or disproportionate to revenues, for the Tax Court's application of section 67. Section 67 and its predecessors speak to the reasonableness of a particular expense. It does not speak to the reasonableness of a particular expense, or expenses collectively, when measured against revenues. There may be instances where the expenses being claimed are so excessive or extravagant as to be unreasonable and, at the same time, so great as to give rise to a loss, and thus the question of whether the taxpayer's venture had a reasonable expectation of profit. But the two issues remain independent of one another. The concept of reasonableness should not be equated with arbitrariness, which best describes the notion that expenses or an expense cannot be disproportionate to revenue, as expressed in the one-third rule (expenses should not ordinarily exceed one third of revenue). If one were to apply such notions strictly, taxpayers might never be able to deduct a business or property loss from other sources of income. Ramsay implies that there must be an —expectation of reasonable profit— as opposed to a —reasonable expectation of profit—. To limit the amount of expenses that can be deducted from income on the ground that they may be disproportionate to revenue is tantamount to saying that a profit of $1 will never be sufficient. Yet, it is sound law that the terms —reasonable expectation of profit— and —expectation of reasonable profit— are not synonymous. The Ramsay line of cases has been displaced by the doctrine of reasonable expectation of profit. Section 67 cannot be invoked to limit an otherwise deductible expense on the ground that it is excessive or disproportionate in relation to revenues.
That a taxpayer has financed the entire purchase price of a property determines nothing. It is both plausible and possible that a taxpayer could acquire property with full financing in circumstances where the rental income is going to exceed all of the rental expenses, including those attributable to interest payments. In such circumstances, it is irrelevant whether acquisition of the property involved full financing and such a business transaction cannot be characterized as unreasonable. However, taxpayers who are unable or unprepared to invest some of their own capital must prove that the rental initiative satisfies the profitability test imposed by Moldowan.
The refusal to permit the taxpayer to deduct interest paid on the $25,000 loan when calculating his rental profit or loss for a particular taxation year was arbitrary and not in accordance with the purpose of section 67. When evaluating reasonableness of an expense, one is measuring its reasonableness in terms of its magnitude or quantum. Although such a determination may involve an element of subjective appreciation on the part of the trier of fact, there should always be a search for an objective component. Where the objective component is difficult to isolate, practical experience informed by common sense will have to prevail. In instances where an expense is of a highly unusual nature or peculiar to a particular type of commercial enterprise, then expert testimony may be instructive. To disallow the deduction of a portion of the interest because of 100% financing is to establish a criterion of arbitrariness and to effectively supplant, erroneously and unjustifiably, the reasonable expectation of profit test with section 67. The decision below was arbitrary because there was no principled basis on which to determine the amount by which the interest expense must be reduced. No reason was given as to why interest on the assumed mortgage should be allowed and that on the personal loan denied. Having regard to the fact that section 67 imposes a criterion of reasonableness, the only rational way of limiting the amount of the interest expense under that provision, without running afoul of the arbitrariness criticism, would be to disallow financing costs at the point where any further interest deduction gives rise to a rental loss. A reasonable expense would be one which does not give rise to a loss. This line of reasoning was, however, unacceptable because it rendered moot the question of whether the taxpayer had a reasonable expectation of profit.
statutes and regulations judicially considered
Income Tax Act, R.S.C., 1985 (5th Supp.), c. 1, ss. 3(d), 9(3), 20(1)(c), 67.
Income Tax Regulations, C.R.C., c. 945, s. 1100(11), (14) (as am. by SOR/90-22, s. 1).
cases judicially considered
applied:
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; Tonn v. Canada, [1996] 2 F.C. 73; (1995), 96 DTC 6001; 191 N.R. 182 (C.A.).
overruled:
Cipollone (N.) v. Canada, [1995] 1 C.T.C. 2598; [1994] E.T.C. 405 (T.C.C.); Ramsay v. M.N.R. (1954), 54 DTC 261 (T.A.B.); Elliott v. M.N.R. (1971), 71 DTC 106 (T.A.B.).
referred to:
Canada (Attorney General) v. Mastri, [1998] 1 F.C. 66 (C.A.); Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536; (1984), 10 D.L.R. (4th) 1; [1984] CTC 294; 84 DTC 6305; 53 N.R. 241; Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32; (1987), 36 D.L.R. (4th) 197; [1987] 1 C.T.C. 117; 87 DTC 5059; 25 E.T.R. 13; 71 N.R. 134; Ludmer (D.) v. M.N.R., [1993] 2 C.T.C. 2494; (1993), 93 DTC 1351 (T.C.C.); Ludmer v. Canada, [1995] 2 F.C. 3; [1996] 3 C.T.C. 74; (1994), 95 DTC 5311; 182 N.R. 125 (C.A.); leave to appeal to S.C.C. refused [1995] 4 S.C.R. vii; Baker (C.B.) v. M.N.R., [1987] 2 C.T.C. 2271; (1987), 87 DTC 566 (T.C.C.); Aucoin v. M.N.R., [1991] 1 C.T.C. 2191; (1990), 91 DTC 313 (T.C.C.); Smith v. R., [1996] 1 C.T.C. 2022 (T.C.C.); Graves (G.) v. Canada, [1990] 1 C.T.C. 357; (1990), 90 DTC 6300; 33 F.T.R. 270 (F.C.T.D.); Qureshi (A.R.) v. M.N.R., [1992] 1 C.T.C. 2370; (1991), 92 DTC 1150 (T.C.C.); 74712 Alberta Ltd. v. M.N.R., [1997] 2 F.C. 471; (1997), 97 DTC 5126; 208 N.R. 348 (C.A.); Maloney (V.) v. M.N.R., [1989] 1 C.T.C. 2402; (1989), 89 DTC 314 (T.C.C.); Fish (S.) v. Canada, [1995] E.T.C. 403 (T.C.C.); Cheesmond (J.E.) v. Canada, [1995] E.T.C. 402 (T.C.C.); Nicols, C. et al. v. The Queen (1997), 97 DTC 1004 (T.C.C.); Pradeepan v. R., [1997] 2 C.T.C. 2015 (T.C.C.); Monga v. R., [1997] 1 C.T.C. 2529 (T.C.C.); Michael (T.P.) v. M.N.R., [1991] 2 C.T.C. 2131; (1991), 91 DTC 1076 (T.C.C.); R v Matthews, D C, [1974] CTC 230; (1974), 74 DTC 6193 (F.C.T.D.); Narine (M.) v. Canada, [1995] 2 C.T.C. 2055 (T.C.C.); Adams v. R., [1996] 1 C.T.C. 2916; (1996), 96 DTC 1145 (T.C.C.).
authors cited
Hogg, Peter W. and J. E. Magee. Principles of Canadian Income Tax Law. Scarborough, Ont.: Carswell, 1995.
APPLICATION for judicial review of the Tax Court's decision reducing the amount of deductible interest under Income Tax Act, section 67 on the ground that 100% financing of the purchase price of a residential rental property was unreasonable (Mohammad v. R., [1997] 1 C.T.C. 2522 (T.C.C.)). Application allowed.
appearance:
Zahid Mohammad on his own behalf.
counsel:
Marie-Thérèse Boris for respondent.
applicant on his own behalf:
Zahid Mohammad, Brampton, Ontario.
solicitors:
Deputy Attorney General of Canada for respondent.
The following are the reasons for judgment rendered in English by
Robertson J.A.: The Minister of National Revenue refused to allow the applicant taxpayer to deduct certain rental losses from employment income on the ground that he had failed to satisfy the —reasonable expectation of profit— test laid down by the Supreme Court in Moldowan v. The Queen, [1978] 1 S.C.R. 480. On appeal, the Tax Court of Canada rejected the Minister's contention [Mohammad v. R., [1997] 1 C.T.C. 2522]. At the same time, the Tax Court Judge invoked section 67 of the Income Tax Act [R.S.C., 1985 (5th Supp.), c. 1] (hereinafter the Act) to reduce the amount of interest that could be deducted for purposes of calculating the rental loss. He did so on the basis that it was unreasonable for the taxpayer to have financed the entire purchase price of the property and then to have deducted all of the interest expense. On the facts of this case, the interest component of the rental expenses was itself sufficient to create a loss even though revenues had not fallen below the taxpayer's expectations.
This judicial review application seeks to establish that the Tax Court Judge erred in reducing the amount of deductible interest under section 67. In my respectful opinion, the taxpayer is entitled to succeed. That being said, it is also evident that there is growing confusion over the proper application of section 67, which speaks to the reasonableness of an otherwise deductible expense, and the judicial doctrine of reasonable expectation of profit. That doctrine speaks to the issue of whether the taxpayer has a —source of income— on which to calculate either a rental loss or profit. These reasons address the fundamental issues of how section 67 is to be applied and how it is to interact with the reasonable expectation doctrine.
In 1987, the applicant taxpayer and Peter Robbins agreed to purchase a residential property in Oakville for rental purposes. Their intention was to rent the property for a few years and then dispose of it, thereby realizing a capital gain. The purchase price was $181,000 with the acquisition being financed by the assumption of an existing first mortgage of $131,000 and by each of the co-owners contributing $25,000 cash. The taxpayer raised his share of the purchase price by obtaining a personal bank loan at the prevailing rate of interest. (In 1991, the personal loan was paid off by increasing the amount of the assumed mortgage.) After purchasing the property in November of 1987, the co-owners were unable to find a tenant immediately. It was therefore agreed that Mr. Robbins would occupy the residential property while paying rent of $1,500 per month, subsequently increased to $1,550 in 1989. In July of 1990, the property was rented to Mr. and Mrs. Slipp for $1,250 per month. Their residential tenure came to an end in August of that year when Mr. Robbins married and he and his wife decided to occupy the property at a monthly rent of $1,300. During the rental period in question, the co-owners had decided against selling the property because of the decline of real estate values in Oakville and the financial (capital) loss they would incur on disposition.
For the 1989, 1990 and 1991 taxation years, the taxpayer's share of the rental losses totalled $7,000, $9,000 and $8,000 respectively. For the 1992 and 1993 tax years, the losses diminished to $4,000 and $1,000. By 1994, the taxpayer reported a modest profit of $760. The Minister disallowed the deduction of rental losses from the taxpayer's other sources of income, namely employment income, on two grounds. First, it was maintained that there was no reasonable expectation of profit and, therefore, no source of income from a property on which a rental loss could be calculated, let alone claimed. Second, it was submitted that in the circumstances the entire interest expense was unreasonable and, accordingly, not deductible pursuant to section 67 of the Act.
Relying on Moldowan, supra and the decision of this Court in Tonn v. Canada, [1996] 2 F.C. 73 (C.A.), the Tax Court Judge held that the rental venture had a reasonable expectation of profit and, therefore, subject to one qualification, the taxpayer was entitled to deduct the rental loss from his employment income for each of the taxation years in question: as to the true import of Tonn, see Canada (Attorney General) v. Mastri, [1998] 1 F.C. 66 (C.A.). The qualification related to the subsequent holding that it was unreasonable for the taxpayer to have acquired the property with full financing. The Tax Court Judge held as follows at page 2527 of his reasons for judgment:
In my opinion, the deductibility of the interest on the borrowed down payment amount was not a reasonable expense. That interest ought to be disallowed under section 67 of the Income Tax Act. It is not reasonable for any individual (or partnership in this case) to purchase real estate; borrow 100% of the cost; and then expect to rent it out and earn a profit after deducting the interest on 100% of the cost.
The Appellant states that his objective was to make a capital gain but, to be a capitalist, one must have some capital. The Appellant did not have any of his own capital in this transaction. It was all borrowed money. As a rental operation, the venture was under-capitalized. The 100% financing of the property was not reasonable.
The taxpayer takes exception to the findings that it was unreasonable to finance 100% of the purchase price and, correlatively, that the interest paid on the $25,000 personal loan was not deductible pursuant to section 67 of the Act. In my respectful opinion, those objections are well founded. For reasons that follow shortly, it is my opinion that it is simply arbitrary to disallow a portion of the interest actually paid by the taxpayer in circumstances where rental property has been acquired with 100% financing. That being said, I think it fairly obvious that section 67 of the Act is being invoked, and improperly so, to address an issue which should be resolved according to the principles of the reasonable expectation of profit doctrine. The true nature and source of the problem is not difficult to discern from the reported jurisprudence and is reinforced by the facts of this case. I take it for granted that any analysis of section 67 must be preceded by one which exposes the true nature of the underlying problem and a proper understanding of the tenets of the reasonable expectation doctrine.
Frequently, taxpayers acquire a residential property for rental purposes by financing the entire purchase price. Typically, the taxpayer is engaged in unrelated full-time employment. Too frequently, the amount of yearly interest payable on the loan greatly exceeds the rental income that might reasonably have been earned. This is true irrespective of any unanticipated downturn in the rental market or the occurrence of other events impacting negatively on the profitability of the rental venture, e.g. maintenance and non-capital repairs. In many cases, the interest component is so large that a rental loss arises even before other permissible rental expenses are factored into the profit and loss statement. The facts are such that one does not have to possess the experience of a real estate market analyst to grasp the reality that a profit cannot be realized until such time as the interest expense is reduced by paying down the principal amount of the indebtedness. Bluntly stated, these are cases where the taxpayer is unable, prima facie, to satisfy the reasonable expectation doctrine. These are not cases where the Tax Court is being asked to second-guess the business acumen of a taxpayer whose commercial or investment venture turns out to be less profitable than anticipated. Rather these are cases where, from the outset, taxpayers are aware that they are going to realize a loss and that they will have to rely on other income sources to meet their debt obligations relating to the rental property.
The facts of this case illustrate the debilitating effect of high-ratio financing on the profitability of a rental venture. For the 1989 taxation year, the taxpayer's share of gross rental income was $9,075. While his share of the expenses amounted to $16,320, the interest component equalled $13,212. In 1990, matters worsened with rental income declining to $8,552 and expenses climbing to $18,182, of which $15,826 was attributed to interest payments. During the taxation years in question, the property was rented and at the market rate. This is not a case where revenues fell below expectations. This is a case where the taxpayer could not reasonably expect to generate a profit until such time as the principal amount of the outstanding purchase-money indebtedness was reduced accordingly.
Lack of immediate profit does not appear to dissuade taxpayers from engaging in the rental market for at least two reasons. First, the anticipated gain on the ultimate disposition of the property may be perceived to overtake any losses stemming from the payment of interest and, more so, if the profit is taxed as a capital gain. (See discussion infra as to the deductibility of interest under paragraph 20(1)(c) of the Act where property is purchased for the purpose of realizing a capital gain.) Second, the impact of the interest expense can be diminished if the rental loss can be deducted from other sources of income, typically employment income, pursuant to paragraph 3(d) of the Act. These tax realities help explain why individual taxpayers avoid the corporate structure as a means of holding ownership in rental properties. It is trite tax law that losses cannot be transferred from one taxpayer to another, except through the most sophisticated of tax planning schemes: see Stubart Investments Ltd. v. The Queen, [1984] 1 S.C.R. 536. Thus, it may be prudent to delay incorporation until such time as a rental property generates a profit. The one remaining tax planning aspect of these transactions is that taxpayers consciously decline the right to claim a capital cost allowance for two reasons. First, the taxpayer has to contend with the recapture provisions of the Act which come into operation on the property's disposition. Second, the Act does not permit taxpayers to use the capital cost allowance to either create or increase a rental loss: see Income Tax Regulations [C.R.C., c. 945] subsections 1100(11) and (14) [as am. by SOR/90-22, s. 1].
Putting aside the above motivational considerations, it is apparent that this group of taxpayers can have no reasonable expectation of profit provided that the interest component of the rental expenses exceeds anticipated gross rental income. Thus, so long as no payments are made against the principal amount of the purchase-money loans, there can be no reasonable expectation of profit. If, however, the interest component of the rental expenses can somehow be reduced then a positive finding of profitability is easier to sustain, which finding will permit the taxpayer to deduct a portion of the rental loss from employment income. One way of achieving that end is to invoke section 67 of the Act. In short, if you reduce the amount of interest being deducted on the ground, for example, that interest paid on a loan obligation involving 100% financing is unreasonable then the reasonable expectation of profit test imposed by Moldowan, supra, may be either avoided or, at the very least, easier to meet. In my respectful opinion, however, section 67 cannot be used in such a manner.
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.
The significance of the taxpayer being able to reduce interest costs by reducing the principal amount of the purchase-money indebtedness and doing so within a reasonable period has not gone unnoticed. It was alluded to in Tonn, supra. Early on in its reasons for judgment, the Court refers to the fact that the taxpayer in that case had paid down the mortgage loan in one of the taxation years in question, a fact that had not been adduced before the Tax Court and which the Minister argued was inadmissible on the application for judicial review (at pages 79-80). In the present case, the taxpayer makes reference in his application record to such payments having been made. That evidence, however, does not appear to have been put before the Tax Court Judge and, in any event, was not raised during the hearing of this application for judicial review because of the limited issue being considered: see applicant's application record, at pages 16-17.
To some, the above analysis might seem unduly pedantic, narrow-minded or simply taxpayer unfriendly. In reply, I would point out that as the law presently stands, interest is not deductible unless paragraph 20(1)(c) of the Act is satisfied. Pursuant to that provision, interest payments are not deductible unless the borrowed money is —used for the purpose of earning income from a . . . property—. Paragraph 20(1)(c) says nothing about property being acquired for the purpose of realizing a capital gain. The existing jurisprudence clearly rejects the understanding that interest is deductible in cases where the interest costs exceed expected revenue because the taxpayer acquired the property for purposes of realizing a capital gain: Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, per Dickson C.J., at page 54; see also Ludmer (D.) v. M.N.R., [1993] 2 C.T.C. 2494 (T.C.C.), appealed on other grounds, [1995] 2 F.C. 3 (C.A.), leave to appeal to S.C.C. denied [[1995] 4 S.C.R. vii]. This conclusion should come as no surprise as the Act distinguishes between income from property and capital gains. Subsection 9(3) expressly provides that income from a property does not include any capital gain from the disposition of that property.
I would also point out that it is difficult to accept that interest being paid on money borrowed to acquire a capital property can be characterized as a —start-up— cost of the kind contemplated by this Court in Tonn, supra. This is not to deny that in other circumstances non-capital start-up costs may help explain, in part, why a taxpayer's rental venture was unprofitable. The reality is that it is much easier for taxpayers to satisfy the Moldowan test and claim a rental loss where the property was acquired without high-ratio financing: see Baker (C.B.) v. M.N.R., [1987] 2 C.T.C. 2271 (T.C.C.); Aucoin v. M.N.R., [1991] 1 C.T.C. 2191 (T.C.C.); and Smith v. R., [1996] 1 C.T.C. 2022 (T.C.C.).
As noted at the outset, this is not a case in which we are called upon to assess a Tax Court's finding respecting whether there was a reasonable expectation of profit. This is a case in which the proper interpretation and application of section 67 of the Act cannot be addressed unless the parameters of the reasonable expectation of profit doctrine are properly understood. Against the foregoing background, I am in a position to address the question of whether the Tax Court Judge erred in refusing to permit the deduction of interest paid on the $25,000 personal loan. This part of my analysis begins with the wording of section 67 of the Act:
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.
It is important to recognize that section 67 does not deal with the issue of deductibility per se but rather with the reasonableness of an expense which is otherwise deductible under the provisions of the Act. The effect of that provision is to limit the extent to which an expense is deductible, that is to an amount which is —reasonable in the circumstances—: see Graves (G.) v. Canada, [1990] 1 C.T.C. 357 (F.C.T.D.), cited approvingly in Qureshi (A.R.) v. M.N.R., [1992] 1 C.T.C. 2370 (T.C.C.). In the case of interest payments, deductibility hinges on paragraph 20(1)(c) and satisfaction of the —direct-use rule— articulated by the Supreme Court in Bronfman Trust, supra: more recently, see 74712 Alberta Ltd. v. M.N.R., [1997] 2 F.C. 471 (C.A.). Since the property in question was not used by the taxpayer as a personal residence and as the Tax Court Judge was satisfied that the arrangement between the taxpayer and the other co-owner was carried out by two unrelated persons on commercially acceptable terms, the issue of deductibility per se did not arise: compare with the facts and result in Maloney (V.) v. M.N.R., [1989] 1 C.T.C. 2402 (T.C.C.). Obviously, the same legal determination could not be made in the case of Mr. Robbins, the other co-owner, who occupied the property as his personal residence.
As noted earlier, the Tax Court Judge disallowed interest paid on the $25,000 personal loan on the ground that 100% financing was itself unreasonable. Counsel for the Minister relies on several cases in support of the position that section 67 of the Act can be so applied. The first is a passing reference in Tonn to the notion that where the Minister wishes to challenge the —reasonableness— of a taxpayer's transactions, consideration should be given to invoking section 67 before resorting to the —heavy-handed— Moldowan test (supra, at page 96). In support thereof this Court referred to a decision of the Tax Court: Cipollone (N.) v. Canada, [1995] 1 C.T.C. 2598 (T.C.C.).
Before addressing the Minister's argument a few preliminary observations are in order. I am going to ignore for the moment the fact that Cipollone did not involve the deductibility of interest expenses but concerned unusually large or —extravagant— clothing and automobile expenses. Moreover, the reference in Tonn to section 67 of the Act being invoked before the reasonable expectation doctrine constituted a general observation which was not applied to the facts of that case. It must be remembered that the legal analysis in Tonn was not intended to be restricted to cases involving rental losses but meant to apply generally to all commercial endeavours.
Cipollone appears to espouse the reasoning adopted in an earlier line of cases beginning with Ramsay v. M.N.R. (1954), 54 DTC 261 (T.A.B.) and Elliott v. M.N.R. (1971), 71 DTC 106 (T.A.B.), without expressly referring to either. In each of those cases, a taxpayer's business expenditures were reduced, not on the ground that a particular expenditure was unreasonable, but on the ground that the total expenses were excessive or disproportionate to revenues. It is in this earlier line of authority that the Minister now seeks to find judicial support for the Tax Court Judge's application of section 67 of the Act. For purposes of this application, I shall confine my analysis to the earliest of the cases relied on, namely, Ramsay. As to the cases in which section 67 has been raised as a possible basis for limiting the amount of interest that is deductible, see: Fish (S.) v. Canada, [1995] E.T.C. 403 (T.C.C.); Cheesmond (J.E.) v. Canada, [1995] E.T.C. 402 (T.C.C.); Nicols, C. et al. v. The Queen (1997), 97 DTC 1004 (T.C.C.); Pradeepan v. R., [1997] 2 C.T.C. 2015 (T.C.C.); Monga v. R., [1997] 1 C.T.C. 2529 (T.C.C.) and Michael (T.P.) v. M.N.R., [1991] 2 C.T.C. 2131 (T.C.C.).
In Ramsay, supra, the taxpayer claimed expenses of $16,405 as against commission revenue of $22,458. The Minister was not prepared to allow the deduction of expenses exceeding $6,836. The Tax Appeal Board's reasoning begins with the observation that the total of the expenses claimed was out of all proportion to the taxpayer's commission income. After referring to an earlier decision in which the Board had expressed the opinion that expenses should not ordinarily exceed one-third of the amount earned, the following was stated at page 262: —This proportion may vary somewhat, of course, but as a rough guide is, I think, a fair yardstick.— After noting that the expenses claimed by the taxpayer equalled two-thirds of revenue, the Board went on to accept the Minister's estimate of reasonable expenses which had been increased to $9,856 during the hearing of the appeal.
Professors Hogg and Magee observe that the Ramsay and Elliott decisions are difficult to understand, and go on to note that the dictum in Ramsay that expenses should not ordinarily exceed one-third of revenue would astonish most business proprietors: see Principles of Canadian Income Tax Law (Scarborough, Ont.: Carswell, 1995), at page 232. I share the Professors' views and would go so far as to hold that this line of authority is no longer of any persuasive force. If the Minister wishes to use the one-third yardstick for administrative purposes, he is free to do so. But as a legal proposition, it carries no weight today and the same is true in regard to the proposition that expenses, individually or collectively, may be deemed unreasonable solely because they are disproportionate to revenues. I adopt this position for several reasons.
Section 67 of the Act, and its predecessors, speak to the reasonableness of a particular expense. The provision does not speak to the reasonableness of a particular expense, nor expenses collectively, when measured against revenues. As a matter of statutory construction, there is simply no room for the interpretation placed by Ramsay on what is now section 67. This is not to deny that there can be instances where the expenses being claimed are so excessive or extravagant as to be unreasonable and, at the same time, so great as to give rise to a loss and thus, the question of whether the taxpayer's venture had a reasonable expectation of profit. But the two issues remain independent of one another.
The concept of reasonableness should not be equated with arbitrariness, which best describes the notion that expenses or an expense cannot be disproportionate to revenue, as expressed in the one-third rule. Moreover, if one were to apply such notions strictly, taxpayers might never be able to deduct a business or property loss from other sources of income. I say this because Ramsay, supra, implies that there must be an —expectation of reasonable profit—, as opposed to a —reasonable expectation of profit—. To limit the amount of expenses that can be deducted from income on the ground that they may be disproportionate to revenue is tantamount to saying that a profit of $1 will never be sufficient. Yet, it is sound law that the terms —reasonable expectation of profit— and —expectation of reasonable profit— are not synonymous: see R v Matthews, D C, [1974] CTC 230 (F.C.T.D.), at page 236.
Further, I think it is self-evident that the Ramsay line of cases (decided prior to Moldowan, supra), has been displaced by the doctrine of reasonable expectation. Curiously enough, the Ramsay approach was far more restrictive than the one articulated in Moldowan, which seeks only to ensure that within a reasonable period the taxpayer realizes a net profit, be it $1 or more. Ramsay suggests that more was required.
In summary, the cases relied on by the Minister, beginning with Ramsay, can no longer be considered good law. Section 67 of the Act cannot be invoked to limit an otherwise deductible expense on the ground that it is excessive or disproportionate in relation to revenues. I turn now to the task of outlining my reasons for rejecting the position adopted by the Tax Court Judge and, correlatively, my understanding of how section 67 is to be applied. My objections to the reasoning adopted below are twofold.
First, the fact that a taxpayer has financed the entire purchase price of a property is by itself determinative of nothing. It is both plausible and possible that a taxpayer could acquire property with full financing in circumstances where the rental income is going to exceed all of the rental expenses, including those attributable to interest payments. Astute real estate speculators are able to ferret out the bargains. In such circumstances, it is irrelevant whether acquisition of the property involved full financing and, most certainly, such a business decision cannot be characterized as unreasonable. In my opinion, there is no legal justification for establishing a rule of law which permits the Tax Court to reduce arbitrarily the amount of interest that is deductible from rental income simply by the Minister showing that the taxpayer obtained 100% financing. That being said, taxpayers who are unable or unprepared to invest some of their own capital must prove to the Tax Court, in accordance with the standard outlined earlier in these reasons, that the rental initiative satisfies the profitability test imposed by the Supreme Court in Moldowan.
I recognize that my first objection is without foundation if the Tax Court Judge intended to limit interest expenses in cases where there was 100% financing and consequently there could be no immediate (reasonable) expectation of profit. Thus, I turn to my second objection. The refusal to permit the taxpayer to deduct interest paid on the $25,000 loan when calculating his rental profit or loss for a particular taxation year is arbitrary and not in accordance with the purpose of section 67 of the Act.
When evaluating the reasonableness of an expense, one is measuring its reasonableness in terms of its magnitude or quantum. Although such a determination may involve an element of subjective appreciation on the part of the trier of fact, there should always be a search for an objective component. When dealing with interest expenses, the task can be objectified readily. For example, it would have been open to the Minister to challenge the amount of interest being paid on the $25,000 loan had the taxpayer agreed to pay interest in excess of market rates. The reasonableness of an interest expense can thus be measured objectively, namely, by reference to market rates. Similarly, the Minister might want to confront a taxpayer who seeks to deduct 3/4 of the interest paid on a mortgage loan pertaining to a duplex in which the taxpayer is residing in one of the two identical units. Once again, the reasonableness of the interest expense being claimed can be measured objectively by reference to area (assuming, of course, that the rental value of a square metre in one part of the property is equal to that in another): see generally Narine (M.) v. Canada, [1995] 2 C.T.C. 2055 (T.C.C.).
I concede that there will be instances where the objective component will be difficult to isolate and, therefore, practical experience informed by common sense will have to prevail. Such is true in respect of those expenses deemed to be unreasonable because they are believed to be excessive or extravagant: see Cipollone, supra, where the taxpayer, a —humourologist—, sought to deduct, for example, significant clothing costs against modest income. Similarly, one can debate ad nauseam what constitutes a reasonable lunch expense or weigh the perceived need of a taxpayer to purchase a Rolls Royce rather than a Chevrolet, Lincoln or a Mercedes-Benz. The problem is that one's understanding of extravagance will be influenced as much by one's professional and business experiences, taken together with personal expectations informed by a particular lifestyle, as by pragmatic considerations related to the objects of the Act. In instances where an expense is of a highly unusual nature or peculiar to a particular type of commercial enterprise, then expert testimony may be instructive: see Adams v. R., [1996] 1 C.T.C. 2916 (T.C.C.). Often it is not difficult to identify and reject the extremes when assessing the reasonableness of an expense. It is what lies in between that remains problematic. But such concerns and considerations do not arise in the present context.
In my respectful view, to disallow the deduction of a portion of the interest because of 100% financing is to establish a criterion of arbitrariness and to effectively supplant, erroneously and unjustifiably, the reasonable expectation of profit test with section 67 of the Act. The decision below is arbitrary because there is no principled basis on which to determine the amount by which the interest expense must be reduced. For example, in the present case, no reason was given as to why interest on the assumed mortgage should be allowed and that on the personal loan denied. The Tax Court Judge could just as easily have denied the deduction of interest paid on the former as opposed to the latter.
The arbitrariness of the decision to reduce the amount of interest that is deductible manifests itself clearly when one speculates as to the extent to which a taxpayer should be entitled to finance the purchase of a rental property before interest payments become non-deductible from rental income. For instance, would it have been acceptable for the taxpayer to deduct all of the interest had the financing been limited to 95%, as opposed to 100%, of the purchase price? Or, should the limit be some other figure? Having regard to the fact that section 67 of the Act imposes a criterion of reasonableness, it seems to me that the only rational way of limiting the amount of the interest expense under that provision, without running afoul of the arbitrariness criticism, would be to disallow financing costs at the point where any further interest deduction gives rise to a rental loss. I say this because it must be presumed that the Tax Court Judge found the taxpayer's attempt to deduct all interest paid to be unreasonable since it necessarily generated a rental loss, irrespective of any other factors. That being the case, a reasonable expense would be one which does not give rise to a loss. Of course, this line of reasoning is unacceptable for it renders moot the question of whether the taxpayer had a reasonable expectation of profit.
From the above reasons, the following key conclusions may be drawn. The judicial doctrine of reasonable expectation of profit and the concept of reasonable expenses under section 67 of the Act are to be invoked and applied independently of one another. The temptation to use section 67 in an arbitrary manner simply to soften the strictures of the reasonable expectation test must be ignored. Granted, the nature of section 67 is more subtle than that of the reasonable expectation doctrine which is inherently an —all or nothing— test: either one does or does not have the requisite expectation; there is no middle ground. Nevertheless, section 67 must be applied in a reasoned manner and as objectively as possible. In the case of interest expenses, reasonableness can be measured objectively and without difficulty. Certainly, the fact that a property was acquired with full financing is not a bar to deducting a rental loss, nor a ground for reducing the amount of interest that is deductible. Correlatively, whether or not an otherwise deductible expense is reasonable in the circumstances is not to be assessed by reference to whether any one expense, or the collective expenses, are considered to be disproportionate to revenues. In this regard, the decisions in Ramsay and Elliott, supra, can no longer be considered good law and the same fate befalls those decisions of the Tax Court which are inconsistent with my conclusions.
In my respectful view, the Tax Court Judge erred in upholding the Minister's refusal to allow the deduction of interest paid on the $25,000 personal loan. Specifically, the error lies in the misinterpretation and misapplication of section 67 of the Act. Accordingly, the application for judicial review must be allowed, the judgment of the Tax Court Judge relating to the deduction of interest on the $25,000 loan set aside and the matter referred back to him for redetermination on the basis that the taxpayer's appeal to the Tax Court of Canada be allowed. The taxpayer is entitled to all reasonable and proper costs of the application.
MacGuigan J.A.: I agree.
McDonald J.A.: I agree.