Real Estate Investors Get Good News From The Supreme Court of Canada
June 25, 2002
Two recent decisions of the Supreme Court of Canada,Stewart v. Canada, and Walls v. Canada, have essentially eliminated the Reasonable Expectation of Profit test whichCanada Customs and Revenue Agency has often used to deny a taxpayer’s deductions in money-losing businesses, rental properties or other commercial investments.
Since its inception in 1978, the REOP test has often been relied upon by CCRA and the courts to deny business deductions frequently targeting losses caused by large interest deductions. In these two companion cases, the Courthas ruled that the REOP test has, in the Court’s view, become a broad-based tool improperly used to second-guess bona fide commercial transactions. If CCRA deemed the venture to have no reasonable expectation of profit, it would deny the taxpayer’s claim for business losses.
The Income Tax Act requires that a taxpayer must have a “source of income ” from a business or property to claim business losses related to that source. The practice ofCCRA was that in situations where it decided that in order for a business or property “source of income ” to exist, the taxpayer had to be able to demonstrate a profit or reasonable expectation of profit. Where a taxpayer could not prove that he or she had a REOP, the taxpayer was deemed to have no commercial ” source of income” from which to deduct business expenses or claim business losses.
In the Stewart case, Mr. Stewart, an experienced real estate investor, acquired four condominiums with a $1,000 deposit. These properties were part of a syndicated real estate development and all units were highly leveraged. Despite the cash-flow projections which were provided to Stewart at the time of purchase, the actual rental experience was significantly worse with the result that Stewart claimed significant losses resulting from the interest expenses on borrowed money to acquire the units. CCRA , upon reassessment, disallowed these losses on the basis that Stewart had no reasonable expectation of profit. The lower courts upheld CCRA ’s position.
Similarly, Mr. Walls was an investor in a limited partnership which acquired a mini warehouse. The partnership generated losses of which Mr. Walls claimed deductions from his proportionate share as a limited partner for income tax purposes. In both Stewart andWalls it did not appear that either investor would ever make a profit.
The Court, in rejecting the REOP test and in deciding these cases, put forth a two-stage approach for evaluating whether a taxpayer’s activities are a source of business or property income and rejected the REOP test.
The test posed by the Court is as follows:
- Is the taxpayer’s activity undertaken in pursuit of profit or is it of a personal nature?
- If it is not of a personal nature, is the source of the income a business or a property?
In circumstances where the nature of the activity is commercial and without a personal element, the taxpayer’s pursuit of profit will be a given and the Court held there is no need to delve any deeper into the taxpayer’s business operations. However, when the nature of the taxpayer’s activity suggests that it could be considered a hobby or other personal pursuit, it will be considered a source of income only if it is undertaken in a sufficiently commercial manner.
The Court has indicated that if the activity is sufficiently commercial to be considered a source of income, CCRA ’s equiry into deductibility should be undertaken using the Act’s provisions as a guide and not the REOP test. In denying the application of the REOP test, the Court stated that “the nature of the test has encouraged a hindsight assessment of the business judgment of taxpayers in order to deny losses incurred in bona fide , albeit unsuccessful, commercial ventures.” Furthermore, the Court held that to deny the deduction of losses on the grounds that the losses signify that no profit exists runs afoul of the language and purpose of the Act.
These two decisions significantly impact the current CCRA policy of denying all business deductions of taxpayers who have been unable to prove that their unprofitable commercial activities were pursued with a reasonable expectation of profit. It removes a significant tool that was used by CCRA to disallow business losses. It is important that you be mindful of these decisions if CCRA is reviewing your business losses with a view of denying their deductibility. If you have already been subject to an audit and your losses have been denied, you should immediately contact your tax advisors to determine whether these two decisions can assist you in making a claim for their deductibility.