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T-956-84 T-957-84
Gerald Armstrong (Plaintiff)
v.
The Queen (Defendant)
Trial Division, Rouleau J.—Toronto, April 16; Ottawa, August 8, 1985.
Income tax — Income calculation — Income or capital gain — Appeal against Minister's reassessment determining pro ceeds from sale of horse constituting business income — Plaintiff in construction business, racing horses as hobby — Horse bought through corporation in 1978, having lucrative, winning record — Following crippling injury, horse sold for stud — Accountants preparing 1981 return, classifying horse as "inventory", declaring one-half proceeds as taxable capital gain — Defendant contending plaintiff having secondary inten tion to sell for profit, making sale adventure in nature of trade and taxable as income — Horse not inventory in sense of property held in course of business, for resale — Circum stances surrounding sale not retroactively converting property held as capital into something of trading nature — Possibility of resale for profit not operating motivation for plaintiff's acquisition — High risk of horse racing not preventing dispo sition of property qualifying as capital transaction — Evidence not establishing existence of secondary intention — Income Tax Act, S.C. 1970-71-72, c. 63, ss. 3 (as am. by S.C. 1977-78, c. 1, s. 1; c. 42, s. 1), 9, 38 (as am. by S.C. 1977-78, c. 42, s. 2), 39(1)(a) (as am. by S.C. 1974-75-76, c. 26, s. 15; c. 50, s. 48; 1976-77, c. 4, s. 9; 1977-78, c. 1, s. 16; c. 42, s. 3; 1980-81-82-83, c. 48, s. 16), 40(1)(a), 54(b), 248(1) (as am. by S.C. 1979, c. 5, s. 66).
The plaintiff has been primarily involved in residential con struction and land development. Having gained an interest in horses, he started by purchasing and selling, through his corpo rations, quarter horses. The horses were trained by himself or his family and raced competitively but never for gain. In the early seventies, the plaintiff began acquiring thoroughbreds for racing and thus, in 1978, purchased "Stone Manor". The horse ran several times in Canada and the United States winning important stakes races and collecting substantial purses. Fol lowing a crippling injury, the horse was sold for stud at a price of $270,000. The accounting firm that prepared the plaintiff's 1981 tax return, described the horse as "inventory" declaring on its disposition a capital gain. In 1983, the Minister of National Revenue reassessed the plaintiff, reclassifying the proceeds from the sale as business income. The plaintiff main tains that the disposition constituted sale of capital property. The defendant contends that the plaintiff had a secondary speculative intention to resell the horse for a profit making the
transaction an adventure in the nature of trade fully taxable as business income.
Held, the appeal should be allowed.
The description of Stone Manor as "inventory" cannot be regarded as providing any indication as to the intentions of the plaintiff. The evidence indicates that, in substance, Stone Manor was not an item of inventory in the sense of property held in the ordinary course of business for resale.
Furthermore, it cannot be inferred from the use of the word "inventory", from the plaintiffs connection with corporations trading in horses and from the high risk nature of horse racing that the plaintiff had a secondary intention to sell his horse for a profit. At the moment of purchase, the plaintiffs operating motivation was not the possibility of resale for a profit. The fact that the circumstances surrounding the sale, that is, the horse's injury and its winning record, made its sale attractive for stud purposes, does not transform retroactively a capital transaction into an adventure in the nature of trade. The evidence does not establish that the purchase of Stone Manor was intended to be a business venture. The plaintiff bought and sold horses as a hobby. The highly speculative nature of horse racing does not mean that disposition of a horse can never qualify as a capital transaction.
The notion of secondary intention was nowhere enshrined in the Income Tax Act. It referred merely to a practical approach for determining certain questions that arise in "trading cases". The notion of secondary intention should be used cautiously so as not to artificially characterize receipts which are properly capital gain as income.
CASES JUDICIALLY CONSIDERED
APPLIED:
Californian Copper Syndicate v. Harris (1904), 5 T.C. 159 (Exch.); Racine v. Ministre du Revenu National, [1965] 2 Ex.C.R. 338; 65 DTC 5098.
REFERRED TO:
Sanders v. M.N.R. (1954), 54 DTC 203 (T.A.B.); Ster ling Trust, Limited v. Commissioners of Inland Revenue (1925), 12 T.C. 868 (Eng. C.A.); Glenboig Union Fire- clay Company, Limited v. Commissioners of Inland Revenue (1922), 12 T.C. 427 (Ct. of Sess.); Bead Real- ties Ltd. v. M.N.R. (1971), 71 DTC 5453 (F.C.T.D.); Hiwako Investments Ltd. v. The Queen (1978), 78 DTC 6281 (F.C.A.); Simmons (as liquidator of Lionel Sim- mons Properties Ltd) v Inland Revenue Comrs, [1980] 2 All ER 798 (H.L.); M.N.R. v. Taylor, J.A. (1956), 56 DTC 1125 (Ex. Ct.); Regal Heights Ltd. v. Minister of National Revenue, [1960] S.C.R. 902; 60 DTC 1270; Irrigation Industries Limited v. The Minister of National Revenue, [1962] S.C.R. 346; 62 DTC 1131; Golden
(G.W.) Construction Ltd. v. Minister of National Reve nue, [1967] S.C.R. 302; 67 DTC 5080; Pierce Investment Corp. v. M.N.R. (1974), 74 DTC 6608 (F.C.T.D.); Ken- sington Land Developments Ltd. v. The Queen (1979), 79 DTC 5283 (F.C.A.); Watts Estate et al. v. The Queen (1984), 84 DTC 6564 (F.C.T.D.).
COUNSEL:
David C. Nathanson, Q.C. for plaintiff. Robert W. McMechan for defendant.
SOLICITORS:
McDonald & Hayden, Toronto, for plaintiff.
Deputy Attorney General of Canada for defendant.
The following are the reasons for judgment rendered in English by
ROULEAU J.: Both cases were tried on common evidence and were the subject of identical argu ment. File T-957-84 was the matter argued and any decision rendered is applicable to file T-956-84.
The issue is to determine whether the purchase of a yearling thoroughbred horse named "Stone Manor", and the sale, some three years after purchase, was a capital disposition or "an adven ture in the nature of trade".
The essential facts are as follows:
The plaintiff, a resident of the Town of Stouff- ville in the Regional Municipality of York, during most of his lifetime has been primarily involved in residential construction and land development. In 1978, accompanied by a thoroughbred horse train er, he attended yearling sales at an auction in Lexington, Kentucky, at which time he purchased a yearling called "Stone Manor" for $28,000 U.S. Stone Manor began its racing career in 1979 and won purses totalling $41,858 and realized a net profit after expenses of $26,852. During the 1980 racing season, it earned $230,708 in purses; yield ing after expenses $98,877.25. In 1981, prior to the end of its racing career, it earned $5,507.50; after deducting expenses there was an operating loss for the year of $19,354.33. In late 1981, because of a crippling injury that could have
resulted in the horse being destroyed, it was retired from racing and sold for $270,000 to a New York State purchaser who intended to use Stone Manor for stud purposes. This value was arrived at because of its success as a racehorse.
In computing his income for the 1981 taxation year, the plaintiff included as a taxable capital gain one-half of the sum realized by him from the sale of Stone Manor after taking into account the adjusted cost base. In October 1983, the Minister of National Revenue reassessed, increasing the liability to tax for the period by $72,912.16. In reassessing the Minister treated Stone Manor as though the horse had been purchased and sold by the plaintiff in the ordinary course of a business and described the plaintiffs proceeds of disposition of Stone Manor as "reclassified as business income". It is with this reassessment that the plaintiff takes issue.
The plaintiff Gerald Armstrong was born on a farm in the Montreal area and remained there until approximately 18 years of age; moved to Toronto, began working with construction firms, and became adept at house building. In 1956 he constructed his first house in the Metropolitan Toronto area. He subsequently became a volume home builder, constructing some 1,000 units a year in Toronto, Ajax, Oshawa and surrounding areas. He was the chief executive officer, principal share holder and driving force behind some three or four home and land development corporations. Between 1975 and 1979 the plaintiffs companies had gross annual sales of between $20,000,000 and $40,000,000. In the fall of 1980 they went into receivership; this he attributes to the recession. Since September, 1982 he has been the president of Victoria Wood Development Corporation which is also in house building and land development.
Having previously acquired a farm property in the Breckin, Ontario area, his interest in riding, developed during his youth, led him toward the purchase of quarter horses. Starting in 1960 and continuing over the next 15 years, through two of
his corporations, he purchased and sold approxi mately 100 quarter horses. His two children enjoyed riding and developed a keen interest in showing horses. The majority of the quarter horses, purchased in the United States, were trained by himself, his children or employees; they were taken to shows and raced competitively with other owners of quarter horses, never for gain, only for ribbons and other similar prizes. During the years that the plaintiff was buying and selling quarter horses, there was no pari mutuel waging in Canada on this type of racing. It should also be noted that he also raised some beef cattle and corn. An ancillary advantage to having horses and cattle on vacant land intended for development, was lower municipal assessment. The farms would be used for this purpose until they became apt for sale or development. Though the farm operations were essentially run by the plaintiff's son from 1980 on, counsel for the defendant tried to show that the plaintiff was intimately involved in run ning this business. The proof of his alleged involve ment is the continued practice by the plaintiff of signing important farm documents.
The plaintiff was originally interested in riding and showing horses; his wife, on the other hand, found her enjoyment in thoroughbred racing. In the early 1970's, through his corporations, he began acquiring thoroughbreds, mostly in claiming races at Ontario tracks. They were of the cheaper variety and ran for claiming prices between $3,000 and $20,000. Testimony indicates that he would have claimed and sold from 15 to 20 horses during this period.
At the time he purchased Stone Manor, it was approximately 18 months old. The horse, as is the custom in thoroughbred racing, turned two years old on the first of January 1979 and, in the spring of that year, commenced training. After realizing that he had an exceptionally fast horse, the plain tiff moved the animal from a public stable to a better trainer who could realize the potential of
this animal. The horse ran three times in Canada in 1979 and once in the United States; in Septem- ber of that year the horse was put to pasture and rested for the winter. In early 1980 the horse was taken to Florida for training and brought back to Ontario where his career as a three-year old began in the spring of 1980; as a three-year old he won important stake races in Ontario, Michigan and Ohio. In the late summer or early fall of 1980, the horse ran in Toronto and was not as successful. The plaintiff was advised by his trainer that the horse was developing a bowed tendon; he was advised "to go easy with it" and rest it through the fall and winter of 1980 and the spring of 1981. They attempted to bring the horse back to the races in 1981 but, after a second poor showing, he was advised by the trainer that the horse was not fit and that if he ran it any further it would end up with bowed tendons, quite a common injury of racing thoroughbreds. In the fall of 1981, a group from New York State was interested in acquiring the horse for breeding purposes. Because of its success they offered and paid the sum of $270,000. The plaintiff testified that he did not keep the horse because he did not have facilities for breed ing, that he was in horse racing for the fun of racing horses, not to raise them since his farm was not equipped for a breeding operation, that this was a hobby and that he happened to get lucky with Stone Manor.
In the spring of 1981, he attended the offices of an accounting firm to have his 1980 taxation return prepared and filed. In one of the schedules attached to his declaration, Exhibit 1, there is a handwritten, crudely drafted statement indicating at the top "Race horse activities, farming income 1980 for George Armstrong". At the very top there are the words "Inventory-1 horse Stone Manor; cost: $28,000 U.S.". It then describes the purses won which amounted to $230,708.15, expenses incurred $131,830.90, showing a net from the operation of $98,872.25. This last amount was reported as income. In his tax return for the taxation year 1981, Schedule 2 indicated the dis-
position of Stone Manor and declared a capital gain.
Both Mr. Armstrong's accountant and the plain tiff testified on the issue of the use of the word "inventory". In cross-examination as well as in examination in chief they advised the Court that the word "inventory" was used for lack of a better expression.
The position of the plaintiff is that the sale of Stone Manor was a sale of a capital property producing proceeds of disposition which are only taxable as capital gains and not as income. He relies inter alia on sections 3 [as am. by S.C. 1977-78, c. 1, s. 1; c. 42, s. 1], 9, 38 [as am. by S.C. 1977-78, c. 42, s. 2], 39(1)(a) [as am. by S.C. 1974-75-76, c. 26, s. 15; c. 50, s. 48; 1976-77, c. 4, s. 9; 1977-78, c. 1, s. 16; c. 42, s. 3; 1980-81-82-83, c. 48, s. 16], 40(1)(a), 54(b) and 248(1) [as am. by S.C. 1979, c. 5, s. 66] of the Income Tax Act [S.C. 1970-71-72, c. 63]. It is contended that there was never any intention ("primary" or "second- ary") to enter into the business of trading in horses for profit.
The defendant on the other hand, argues that the sale of Stone Manor resulted in a profit from a business or an adventure in the nature of trade which is fully taxable as income. The defendant relies, inter alia, on sections 3, 9 and 248(1) of the Act. The phrase "adventure in the nature of trade" is drawn from the extended definition of "busi- ness" found in subsection 248(1). While admitting that Stone Manor was acquired to be kept and raced, the main contention of the defendant is that the plaintiff had a speculative intention of selling Stone Manor for a profit. This secondary intention is said to impart to the sale the characteristics of an adventure in the nature of trade making the proceeds fully taxable as income.
Though downplayed by the defendant in argu ment, considerable attention at trial was devoted to the implications of the description of the horse as "inventory" in the plaintiff's 1981 tax return. It is alleged by the defendant that this provides an indication that the plaintiff was engaged in the business of buying and selling racehorses with the result that the excess of the price over costs should
be regarded as profit from that business and taxed as income. I do not draw such an inference. The definition of "inventory" in subsection 248(1) is too broad to be of any great help and only defines the term for the purposes of the Act and not for the interpretation of the intent of a taxpayer. It is well established that a taxpayer can neither increase nor decrease his tax liability by the inten tional or erroneous use of magic words in his accounts. The words used may be indicative of the nature of a transaction. However, in the final analysis the task for this Court is to decide on the actual nature of the transaction and the substance of the matter on the basis of all the facts and circumstances. See Sanders v. M.N.R. (1954), 54 DTC 203 (T.A.B.), at page 204; Sterling Trust, Limited v. Commissioners of Inland Revenue (1925), 12 T.C. 868 (Eng. C.A.) per Pollock, M.R. at page 882 and per Atkin L.J. at page 888; and, Glenboig Union Fireclay Company, Limited v. Commissioners of Inland Revenue (1922), 12 T.C. 427 (Ct. of Sess.) per Lord President Clyde at page 450. On the basis of the evidence, it is my view that in substance Stone Manor was not an item of inventory in the sense of a property held in the ordinary course of business for resale.
This brings me to the more general question of secondary intention. The defendant urges me to infer, from the description of Stone Manor as "inventory", from the plaintiff's connection with corporations trading in horses and from the speculative or high-risk nature of the purchase of racehorses, that the plaintiff had, from the outset, a secondary intention of turning his horse to profit. I think the evidence and the law lead to the opposite conclusion, and it is on this basis that I must decide. As Lord Justice Clerk so aptly said in deciding whether the gain from the sale of certain shares amounted to a profit from a business tax able as income or was merely a (then) untaxable capital gain in the case of Californian Copper Syndicate v. Harris (1904), 5 T.C. 159 (Exch.), at page 166:
What is the line which separates the two classes of cases may be difficult to define, and each case must be considered accord ing to its facts; the question to be determined being—Is the
sum of gain that has been made a mere enhancement of value by realising a security, or is it a gain made in an operation of business in carrying out a scheme for profit-making?
The case of Racine v. Ministre du Revenu Na tional, [1965] 2 Ex.C.R. 338; 65 DTC 5098 is useful for its treatment of the notion of a second ary intention to sell a property (in that case a business) for profit which converts a transaction or series of transactions into an adventure in the nature of trade. At page 348 Ex.C.R.; 5103 DTC of the unofficial translation (see page 5111 DTC in the original French text) Noël J. said:
In examining this question whether the appellants had, at the time of the purchase, what has sometimes been called a "secondary intention" of reselling the commercial enterprise if circumstances made that desirable, it is important to consider what this idea involves. It is not, in fact, sufficient to find merely that if a purchaser had stopped to think at the moment of the purchase, he would be obliged to admit that if at the conclusion of the purchase an attractive offer were made to him he would resell it, for every person buying a house for his family, a painting for his house, machinery for his business or a building for his factory would be obliged to admit, if this person were honest and if the transaction were not based exclusively on a sentimental attachment, that if he were offered a sufficiently high price a moment after the purchase, he would resell. Thus, it appears that the fact alone that a person buying a property with the aim of using it as capital could be induced to resell it if a sufficiently high price were offered to him, is not sufficient to change an acquisition of capital into an adventure in the nature of trade. In fact, this is not what must be understood by a "secondary intention" if one wants to utilize this term.
To give to a transaction which involves the acquisition of capital the double character of also being at the same time an adventure in the nature of trade, the purchaser must have in his mind, at the moment of the purchase, the possibility of reselling as an operating motivation for the acquisition; that is to say that he must have had in mind that upon a certain type of circumstances arising he had hopes of being able to resell it at a profit instead of using the thing purchased for purposes of capital. Generally speaking, a decision that such a motivation exists will have to be based on inferences flowing from circum stances surrounding the transaction rather than on direct evi dence of what the purchaser had in mind.
See also: Bead Realties Ltd. v. M.N.R. (1971), 71 DTC 5453 (F.C.T.D.) per Walsh J.; Hiwako Investments Ltd. v. The Queen (1978), 78 DTC 6281 (F.C.A.); and Simmons (as liquidator of Lionel Simmons Properties Ltd) v Inland Revenue Comrs, [ 1980] 2 All ER 798 (H.L.) per Lord Wilberforce especially at the bottom of page 802. A common thread running through these cases is that circumstances which force the sale of a prop-
erty or make such a sale attractive (in this case the horse's injury combined with its winning record making it valuable for stud) do not have the effect of retroactively converting a property held to pro duce income and as a capital property into some thing of a trading nature.
Upon evaluation of all of the evidence and cir cumstances I am not prepared to find that, at the moment of purchase of Stone Manor, the possibili ty of resale for profit was an operating motivation of the plaintiffs acquisition. I am satisfied that there was no secondary intention in buying Stone Manor to sell him for a profit rather than keep him for racing. The evidence is to the contrary. He was carefully chosen as a good racehorse, he was trained and in fact raced. A good income derived from the purses won. The sale was motivated by an unfortunate and unforeseeable leg injury which brought his racing career to an abrupt end. It has not been demonstrated to my satisfaction that the plaintiffs connection with corporations trading in horses (mostly quarter horses) coloured his person al acquisition of a racing thoroughbred so as to make the notion of secondary intention applicable in this case. A taxpayer's connection with real estate buying and selling operations has not lead to the conclusion in other cases that the gain from the sale of property must be viewed as income: Racine v. Ministre du Revenu National, supra at page 351 Ex.C.R., in translation at page 5104 DTC and in the original French text at page 5113 DTC; and, Bead Realties Ltd. v. M.N.R., supra at page 5454. This is surely all the more so when, as in the case at bar, the property sold was bought for the purposes of pursuing a hobby.
It is certainly true that an isolated transaction may be characterized as "an adventure in the nature of trade" so that any resulting profit is taxable as income: M.N.R. v. Taylor, J.A. (1956), 56 DTC 1125 (Ex. Ct.), at page 1138. However, in the case at bar there is no evidence whatsoever that the plaintiff intended the purchase of Stone Manor to be a business venture. He had no breed ing operation on any of his farms and there was not even any evidence of breeding of quarter
horses by the corporations which had bought and sold such horses. If anything his conduct was characteristic of someone who had a hobby. I am not convinced that signing documents related to the farm operations in general made the running and eventual sale of Stone Manor into a business venture for the plaintiff. He enjoyed riding, show ing and racing horses. There is no evidence before me that any profit was ever before made through this hobby which would indicate a secondary intention of selling the horse for profit. The plain tiff was a land developer and house builder. His corporations were conducting $20 to $40 million of business per year when he bought Stone Manor. Even after his building corporations went into receivership he did not turn his energies to the horse breeding business despite Stone Manor's value as demonstrated by its eventual sale for $270,000. Instead, in 1982, he returned to the land development and house building business and became president of the Victoria Wood Develop ment Corporation.
The key element of the defendant's argument seemed to be that because the purchase of horses for racing is highly speculative, with little assur ance of winnings, Stone Manor must have been bought with a view to eventual sale and not as an income producing asset. This is said to make the present case different from other cases where a secondary intention is not found. I must say I cannot really follow or endorse this line of argu ment. On such logic every person who purchases property to pursue a hobby is, for income tax purposes, in the business of buying and selling that type of property. It is true there was no assurance of success. However, there are many other highly speculative purchases one can make, for example of paintings, without such a characteristic being determinative of the intention of the buyer. It seems to me that the defendant's theory amounts to saying that the plaintiff bought something which he could not expect to produce income, but which he at the same time expected to sell for a considerable profit. This theory makes no sense in the present context. In the case of the racehorse, increased value at the time of sale can only come from its income producing capacity and potential
or a record of winnings which makes it valuable for breeding. Thus, absence of expectation of income will also exclude expectation of a high resale value. This is perhaps different from cases of land purchase where the land may have almost no income producing capacity but can still be expected to fetch a handsome price upon resale. Statements about the effects of a purchase being speculative in nature on the characterization of the gain from the eventual sale which are found in Regal Heights Ltd. v. Minister of National Reve nue, [ 1960] S.C.R. 902; 60 DTC 1270, at pages 905-907 S.C.R.; 1272-1273 DTC appear to sup port the defendant. On the other hand the later decision of the Supreme Court in Irrigation Industries Limited v. The Minister of National Revenue, [1962] S.C.R. 346; 62 DTC 1131 sug gests at pages 349-352 S.C.R.; 1132-1133 DTC that a high level of risk does not mean that the disposition of a property can never be considered a capital transaction.
In conclusion I would like to briefly return to the question of secondary intention. The notion of secondary intention is nowhere enshrined in the Income Tax Act. As the Chief Justice of the Federal Court stated in Hiwako Investments Ltd. v. The Queen, supra at page 6285 the term "secondary intention":
... does no . more than refer to a practical approach for determining certain questions that arise in connection with "trading cases" but there is no principle of law that is repre sented by this tag. The three principal, if not the only, sources of income are businesses, property and offices or employments (section 3). Except in very exceptional cases, a gain on the purchase and re-sale of property must have as its source a "business" within the meaning of that term as extended by section 139 [now section 248(1)].
The purchase and eventual sale of Stone Manor was neither a business nor an adventure in the nature of trade.
An ahistorical and entirely positivist approach to the use of cases decided before the 1971 tax reform may create the risk of arbitrary distortions in the interpretation and application of the Income Tax Act. One cannot ignore the fact that cases like M.N.R. v. Taylor, J.A., supra; Regal Heights Ltd. v. Minister of National Revenue, supra; Golden (G. W.) Construction Ltd. v. Minister of National
Revenue, [1967] S.C.R. 302; 67 DTC 5080; Pierce Investment Corp. v. M.N.R. (1974), 74 DTC 6608 (F.C.T.D.); Kensington Land Developments Ltd. v. The Queen (1979), 79 DTC 5283 (F.C.A); and, Watts Estate et al. v. The Queen (1984), 84 DTC 6564 (F.C.T.D.), all cited by the defendant, were decided in respect of taxation years when failure by the courts to find that the amount in dispute was income would have freed the taxpayer from all tax liability. Such was not the case after 1971, at least until the 1985 federal budget. Capital gains were taxable and Parliament, in its wisdom, set the tax rate at one-half of that on income. In this historical and statutory context, the notion of secondary intention should be used cautiously so as not to artificially characterize receipts which are properly capital gain as income.
For all of these reasons the appeal is allowed and the plaintiff will be entitled to his costs.
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