R.M. Inc. (RMI) manufactures earth-moving and excavation equipment. RMI is owned and managed by Ross Meister. It is now February 15, 20X2. Meister has asked you to help the company deal with a tax problem. The CRA is questioning the capital gains treatment of a 20X1 sale of land by RMI; it believes that the full amount of the gain should have been included in income.

Meister wants to know what arguments the CRA will likely present and how RMI can counter them. Also, he wants to know what the tax consequences will be if the CRA succeeds in making an adjustment. Details of the land transaction are offered below.

RMI purchased 50 hectares of vacant land in an industrial park on December 2, 20X0, for $1.35 million. The purchase was financed, in part, by a five-year first mortgage of $500,000 with interest at 12%. At first, Meister intended to move RMI from its current location to the new location just north of Toronto. He knew that even if he decided later not to move from his current premises, he had purchased the land at a bargain price and would be able to make a profit if he sold it.

On April 1, 20X1, RMI accepted an offer of $3.68 million for 40 hectares of the vacant land. RMI took back a $685,000 first mortgage, repayable at $30,000 per year, with the balance due in 20X6. In RMI’s 20X1 corporate tax return, the land disposition was recorded as a capital gain. The remaining 10 hectares of land were retained by RMI.

Meister decided to build RMI’s new warehouse on the 10-hectare site. RMI will retain its current location as a garage for storing and servicing construction equipment. RMI is subject to a 25% tax rate on all of its income.

Required:

Prepare a brief report that answers Meister’s questions.