Builders and house flippers attempting to profit off the supercharged real estate market in Canada should all be aware of the decision in Wall v Canada, 2021 FCA 132, in which the Federal Court of Appeal dismissed the taxpayer's appeal of the Tax Court's decision to deny a claim for the principal residence exemption on the sale of three real properties, treat the sales as business income rather than capital gains, subject the sales to GST/HST, and impose gross negligence penalties.

Background and Reassessment

The taxpayer in Wall was a licensed real estate agent who had significant experience developing real estate. In 2006, 2008, and 2010, the taxpayer developed and sold three residential properties, claiming the principal residence exemption in each case. The taxpayer did not report any income nor charge GST/HST in connection with these sales. The CRA reassessed the taxpayer to deny his claim for the principal residence exemption for each of the properties, and to include the full amounts of the properties as business income for the purposes of income tax and GST/HST.

The Tax Court

The main issue at the Tax Court was whether the gains on the three properties should be taxed as a capital gain as claimed by the taxpayer, or on account of business income. A secondary issue was whether the taxpayer was a "builder" under the Excise Tax Act ("ETA"), such that the dispositions were subject to GST/HST.

The taxpayer argued that he resided in each of the properties with his son as a permanent residence and therefore was entitled to the principal residence exemption. The Tax Court was unpersuaded for several reasons. One reason was that the taxpayer retained very little documentation with respect to the properties, including evidence documenting the development process or demonstrating that the taxpayer and his son ever lived in the properties. The Tax Court also found the taxpayer's testimony to be "largely unreliable, self-serving, and evasive."

The Tax Court held that the property sales were on income account. The court analyzed the factors for determining whether a gain is on income or capital account as summarized in Happy Valley Farms Ltd. v. Minister of National Revenue, [1986] 2 CTC 259 (FCTD):

  1. The nature of the property sold;
  2. The length of the period of ownership;
  3. The frequency or number of similar transactions;
  4. Work expended on or in connection with the property;
  5. The circumstances that were responsible for the sale of the property; and
  6. Motive.

 Applying these factors, the Tax Court considered the following:

  1. The nature of the housing market in which the houses were sold was speculative and the taxpayer, with his level of business expertise in real estate, would have known about the significant resale value of the properties. 
  2. The taxpayer owned each property for a relatively short period of time.
  3. The taxpayer had previously engaged in frequent and similar transactions of residential real estate as a property developer.
  4. The taxpayer put significant work into developing the properties and realized the substantial profit from these efforts as soon as the properties were fully developed. 
  5. The taxpayer's claim that he sold the homes to pay off high debt was inconsistent with the evidence on record; the taxpayer did not use any of his other liquid assets to pay off his debt, and he entered into increasingly expensive mortgages upon each house sale.
  6. The taxpayer's testimony about his motive to reside in each property with his son was inconsistent with all of the objective evidence.

The Tax Court also held that the taxpayer's sales were subject to GST/HST. One of the ways a person is subject to GST is if they qualify as a "builder" under the ETA. A "builder" includes a person that carries on, or engages another person to carry on, construction of a residential complex in the course of a business or an adventure or concern in the nature of trade. In light of the fact that the taxpayer engaged contractors to develop the properties, and in light of the finding that the taxpayer was carrying out a business, the taxpayer qualified as a "builder" under the ETA.

Lastly, the Tax Court upheld penalties imposed on the taxpayer for knowingly making false statements or omissions, being willfully blind and grossly negligent, and failing to collect, remit or report any GST/HST in all three taxation years.

The Federal Court of Appeal

The main issue on appeal was whether the Tax Court erred in determining that the taxpayer constituted a "builder" under the ETA. This question turned on the accuracy of the Tax Court's finding that the taxpayer developed the properties as part of a business.

The FCA found there was no basis to overturn the Tax Court's conclusion, and that the taxpayer was a "builder" under the ETA. In reaching its conclusion, the FCA noted the value of objective demonstrations of purpose when characterizing the nature of property disposition, adopting the Supreme Court of Canada's claim in MacDonald v. Canada, 2020 SCC 6 that "ex-post facto testimony regarding [a taxpayer's] intentions cannot overwhelm the manifestations of a different purpose ascertainable from the record."

Conclusion

Wall illustrates how the credibility of a taxpayer's testimony remains important in demonstrating intent, but taxpayers must be ready and able to support their stated intention with clear and comprehensive evidence. This is particularly true in the realm of real estate development, where houses can serve dual purposes and do not, on their own, indicate a capital or business intent.

For more information, visit our Canadian Tax Litigation blog at www.canadiantaxlitigation.com

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