Halak v. MNR, 89 DTC 531, [1989] 2 CTC 2273 (TCC)

Rip, T.C.J.: —Joseph Halak ("Halak") appeals his income tax assessments for 1983 and 1984 on the basis he be permitted to deduct in computing his income for these years pursuant to subsection 37(1) of the Income Tax Act ("Act") expenditures incurred by him purportedly in respect of scientific research in those years in amounts by which the aggregate of such amounts does not exceed expenditures of a current nature made by him on scientific research in the years 1980 to 1982 inclusive. The Minister of National Revenue, the respondent, allowed the appellant to deduct only $5,000 of his expenses on the basis he was carrying on the business of farming but that farming was not his chief source of income in 1983 and 1984: subsection 31(1) of the Act.

Halak is a physician. He appears to be an enthusiastic, imaginative and confident gentleman. He promoted the first strata medical building in British Columbia; he has been in the urethane business and has fished commercially. He more recently has been in the business of building homes for sale. It appears that all the while he continued to carry on his profession.

Sometime in the late 1970s Halak observed wet hay on farmers' fields and wondered why it had not been stored. He realized wet hay has a reduced nutritional value and low market value. After speaking to farmers and reading various brochures he learned that because of limits to weather forecasting, farmers cut only 10 to 15 acres of hay for storage at any one time. Apparently, according to Halak, earlier this decade the federal weather office was able to predict weather conditions with 100 per cent accuracy for only 48 hours. All a farmer could cut and store in 48 hours, Halak learned from farmers, was 10 to 15 acres of hay. He was of the view there ought to be a better system of cutting and storing hay to prevent spoilage on the fields. He studied methods how to prevent hay from getting wet and how to bring larger acreage under cover at any one time.

Halak insisted he was not concerned how hay was grown or with growing hay. He focused on gathering hay once cut and sheltering it before it rained.

Halak investigated hay cutting and storing procedures at the time. He spoke to employees at the weather office and to farmers. A farmer could make three cuts each year; during the first week of June, six weeks later in mid-July and a smaller cut in mid-August, depending on the maturity of the hay and the weather. This information served as the starting point of his work.

The conventional method of harvesting hay was described by Halak as slow. The most up-to-date method at the time could not cut and store more than the 10 to 15 acres. Halak described the most efficient and conventional method. The hay is cut when considered mature. Once cut it is placed in a windrow. From the windrow it is tedded; a machine, pulled by a tractor, grabs the hay in the windrow and spreads it “all over the place” so as to permit air to get into the hay strands to allow drying. This procedure is performed two or three times. Once dry the hay is put back into the windrow by machine (either a rake or the tedding machine). The hay is then gathered into bales, a normal size being 16 x 14 x 42 inches and having a weight of 60 pounds. An average acre would yield approximately 100 bales. Once baled, the hay is left in rows along the ground. An automatic bale wagon collects the bales, stacks them in racks and when the wagon is full, it is taken to a barn where the hay is unloaded and stored.

Halak investigated systems available to farmers by reading manufacturers' promotional literature. The "state of the art" at the time was a Model 1063 Sperry Automatic Bale Wagon; the period of retrieval of the hay to storage with this machine was six hours. Another Sperry Bale Wagon, Model, No. 1037, took eight hours. Halak's objective was to retrieve and store 40 acres of hay in six hours at a lower cost than the conventional system and he did in fact devise such a system for which he received a patent (no. 1160580) from the Canadian Patent Office in January of 1984.

To develop his system in 1980, Halak purchased a 43 acre farmland 75 miles east of Vancouver for $201,000. He paid a $20,000 downpayment and the balance was financed by the vendor taking back a mortgage.

Halak's invention provided a method and apparatus for handling and storing baled hay. The invention consisted of a tractor pulling an ordinary hay wagon - a flat bed - with a pop-up loader attached to the wagon. (A popup loader is a machine which lifts bales from the ground and deposits them on the wagon.) On the wagon sat a portable barn for hay which had the shape of a railway boxcar, although smaller. The portable barn had a wooden floor, its ends were covered by angle tin. The size of the portable barn was 8 feet by 16 feet; each barn could hold 200 bales of hay and could be transported legally on a public road on a flatbed truck. As the bales were dropped on the wagon the bales would manually be placed into the barn.

When the barn was full, a modified fork lift would lift it from the wagon and place it on the field. A sectional roof would be placed over the barn. A fork lift would then pick up an empty barn and place it on the wagon. The process would continue. The barn sheltered the hay from rain and snow.

The portable hay barn could be set down anywhere on the farmer's field and could lie side by side with other portable barns. Neither a bale wagon nor a conventional barn was required.

The cost of the system devised by Halak approximated $20,000 for tractor, pop-up loader, hay wagon with fork lift and one portable barn. A portable barn cost $400 and Halak built 22 such barns, two more than the number required to harvest and store 40 acres of hay (i.e., each acre yields 100 bales of hay). The two extra barns were to replace any damaged barns.

Halak admitted the hay wagon was “nothing special”, although it was slightly modified to ensure the barn would not fall off. The tractor had sufficient horsepower, approximately 45 horse power, to pull a full load on level terrain. Three persons were required from the picking up of the bales

to storing them in the barn: one person on a tractor, another person to place the bales in the barn and a third to drive the fork lift.

Halak first tested his system with the first cut of hay on June 4, 1982, after receiving confirmation of no rain for 48 hours. He commenced to cut at 5:00 a.m. and finished cutting some time between 10:00 a.m. and 10:30 a.m. He tedded as he cut, then dried and tedded again. He finished work the first day at 4:00 p.m. The next morning the tedding procedure was repeated; at about 1:30 p.m. the hay had dried to 23 per cent moisture. The hay was droned and then baled by the new system. The first day consisted essentially of cutting and drying the hay. The second day was spent getting the hay to the barn. By 10:00 p.m. the second day all the hay was in the barns. However, because of flooding of the Fraser River earlier in 1982, seven to eight acres of his farm were still under water; the test was done on 33 acres. The time period between the commencement of retrieving the bales to storage was six hours.

In August the same procedure was used for the second test over the 40 acres. This test also took six hours.

In devising his system, Halak did much, if not most, of the work himself on the site of the farm. Modification to the fork lift, increasing the width of the fork, and the construction of the iron frames for the barn were performed by others. Halak experimented in using different material for the barns, for example he found that neither wood nor tubular ends were satisfactory but that angle iron was best material for the ends of the barn. Halak did not make any notes of his research, in particular of his failures and successes as the system developed. There were no journals or field notes describing his progress, although some notes of calculations were prepared about two months before the first test.

Once Halak completed the second test in August 1982 he ceased his research and development and in 1983 he leased the property to a farmer. He listed the property for sale in 1983 or 1984. He never marketed the system, although his object in developing the system was to manufacture and market.

Halak relies on subparagraph 37(1)(a)(i) of the Act which in 1983 and 1984 provided that:

There may be deducted in computing the income for a taxation year of a taxpayer who carried on a business in Canada and made expenditures in respect of scientific research in the year the amount by which the aggregate of

(a) such amounts as may be claimed by the taxpayer not exceeding all expenditures of a current nature made in Canada by the taxpayer in the year or in any previous taxation year ending after 1973

(i) on scientific research related to the business and directly undertaken by or on behalf of the taxpayer.

The meaning of “scientific research” in paragraph 37(7)(b) has the meaning given to that expression by section 2900 of the Regulations to the Act. The relevant portions of this Regulation read as follows:

For the purposes of this Part and paragraphs 37(7)(b) and 37.1(5)(e) of the Act, “scientific research” means systematic investigation or search carried out in a field of science or technology by means of experiment or analysis, that is to say,

(b) applied research, namely, work undertaken for the advancement of scientific knowledge with a specific practical application in view.

For Halak to be successful he must establish, amongst other things, that in the years in appeal he both carried on a business in Canada and made expenditures in respect of scientific research.

The respondent disallowed Halak's expenditures since they had not been shown to have been made or incurred for the purpose of gaining or producing income from a business within the meaning of paragraph 18(1)(a) and subsection 37(1) of the Act. The respondent pleaded no other facts in support of his assessment.

Almost all of the expenditures totalling $96,135 sought to be deducted by Halak were incurred in 1980, 1981 and 1982. These amounts are deductible in 1983 and 1984: paragraph 37(1)(a). However, subsection 37(1) permits the deduction of the amounts in 1983 and 1984 if the taxpayer "made expenditures in respect of scientific research” in the years he claims the deductions.

Halak says he ceased his experiment after the second cut in 1982. During the years 1983 and 1984 he incurred interest expenses on the mortgage on the farm property and with respect to his application for a patent. Annual interest expenses for 1983 and 1984 were $13,200; his patent expenses aggregated $2,306.61 in 1983.

For the years in appeal subsection 37(4) provided that:

No deduction may be made under this section in respect of an expenditure made to acquire rights in, or arising out of, scientific research.

Counsel for the appellant did not submit that interest expenses were expenditures with respect to scientific research.

Counsel for the appellant submitted that subsection 37(4) was to prohibit a deduction to taxpayers of amounts expended to purchase patent rights in an invention from another person. He argued that subsection 37(4) does not prohibit expenses laid out to acquire a patent of one's own invention. Counsel relied on the appeal of Stromotich v. M.N.R., [1986] 1 C.T.C. 2105; 86 D.T.C. 1032 where the particular expenditures in question had been incurred after the scientific research had been completed. Counsel emphasized that in that case the Minister conceded that scientific research included the obtaining of a patent and he cited Sarchuk, T.C.J. at page 2111 (D.T.C. 1037):

Counsel for the respondent agreed that in the years prior to 1979 Stromotich was involved in activities with respect to engineering or design and was doing scientific research. The respondent submits however, that following the completion and the patenting of his invention the appellant was no longer doing scientific research but was involved either in activities with respect to market research or in sales promotion.

Counsel asked me to observe that the Minister did not argue and the Court did not hold, that the taxpayer's research in Stromotich, supra, stopped following the completion of the invention and before the obtaining of the patent. He therefore concluded the obtaining of a patent is part of scientific research.

Unfortunately for the appellant, I do not interpret the excerpt quoted from Stromotich, supra, in the same manner as did his counsel. Whether the costs of obtaining a patent constitute part of scientific research was not before the Court in Stromotich. The completion and patenting of the invention was simply a convenient starting point for the commencement of market research or sales promotion activities. Later on, at page 2115 (D.T.C. 1038), Sarchuk, T.C.J. concludes patent activity is not scientific research, when he states ”. . . although he continued to press for further patents in 1983 this does not bring him within the scope of the provisions of Regulation 2900(c) . . .”, i.e. scientific research. Expenditures to acquire a patent are not in respect of scientific research; expenditures in respect of scientific research are expenditures for scientific research. [1]

My understanding is that a patent is granted to an inventor after the invention has been created The patent is a result of the invention arrived at by scientific research. The patent generally accords the inventor certain privileges, in particular the exclusive right to exploit the invention for profit for a limited time.

The expenditures for the patent were incurred to acquire rights, the patent, arising out of scientific research. Had Halak not carried on his experiments he would not have been eligible to acquire a patent. The Act prohibits the deduction of such expenditures.

Since I have found the appellant made no expenditures in respect of scientific research in the years of appeal I need not consider whether he incurred expenditures for scientific research in prior years. Subsection 37(1) does not permit the appellant to deduct the expenditures made purportedly in respect of scientific research in computing his income for 1983 and 1984.

The appeals are dismissed.

Appeals dismissed