DesChênes v. The Queen, 93 DTC 5234, [1993] 2 CTC 107 (FCTD)

Pinard, J.:— The plaintiffs, Michel DesChênes and his wife Ghislaine DesChênes, appeal from the reassessments of income tax for the 1983, 1984 and 1985 taxation years. In making each of the reassessments the defendant disallowed the losses incurred by the plaintiffs in the yacht-charter operation they conducted during those years and denied them the benefit of the capital cost allowance provisions for certified vessels. The defendant did so on the basis that the yacht-charter operation conducted by the plaintiffs did not have a reasonable expectation of profit in any of those years. The appeals were heard together on common evidence.

The applicable statutory provisions in these income tax appeals are subsections 9(1), 9(2) and 248(1), and paragraphs 18(1)(a), 18(1)(h) and 20(1)(a) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act") and subsequently for the 1983,1984 and 1985 taxation years:

9.(1) Subject to this Part, a taxpayer’s income for a taxation year from a business or property is his profit therefrom for the year.

(2) Subject to section 31, a taxpayer’s loss for a taxation year from a business or property is the amount of this loss, if any, for the taxation year from that source computed by applying the provisions of this Act respecting computation of income from that source mutatis mutandis,

18.(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

(h) personal or living expenses of the taxpayer except travelling expenses (including the entire amount expended for meals and lodging) incurred by the taxpayer while away from home in the course of carrying on Pis business;

20.(1) Notwithstanding paragraphs 18(1)(a), (b) and (h), in computing a taxpayer's income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto:

(a) such part of the capital cost to the taxpayer of property, or such amount in respect of the capital cost to the taxpayer of property, if any, as is allowed by regulation;

248.(1) In this Act,

“business” includes a profession, calling, trade, manufacture or undertaking of any kind whatever and, except for the purposes of paragraph 18(2)(c), an adventure or concern in the nature of trade but does not include an office or employment;

"personal or living expenses" includes

(a) the expenses of properties maintained by any person for the use or benefit of the taxpayer or any person connected with the taxpayer by blood relationship, marriage or adoption, and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit,

(b) the expenses, premiums or other costs of a policy of insurance, annuity contract or other like contract if the proceeds of the policy or contract are payable to or for the benefit of the taxpayer or a person connected with him by blood relationship, marriage or adoption, and

(c) expenses of properties maintained by an estate or trust for the benefit of the taxpayer as one of the beneficiaries;

The regulations in these income tax appeals are regulations 1100(1)(v), 1100(3), 1101(2a) and 1102(1)(c) of the Income Tax Regulations, as amended for the 1983, 1984 and 1985 taxation years. These regulations establish the criteria for the deduction from income of capital cost allowance in respect of vessels, such as that owned by the plaintiffs. The applicable portions of these regulations state:

1100.(1) For the purposes of paragraph 20(1)(a) of the Act, there is hereby allowed to a taxpayer, in computing his income from a business or property, as the case may be, deductions for each taxation year equal to

(v) such amount as he may claim in respect of a property that is

(i) a vessel in respect of which the Minister of Industry, Trade and Commerce has certified as provided in subsection 1101 (2a), . . .

not exceeding the lesser of

(iv) where the property was acquired in the taxation year and after November 12, 1981, 16-2/3 per cent of the capital cost thereof to him and, in any other case, 33-1/3 per cent of the capital cost thereof to him, and

(v) the undepreciated capital cost to him as of the end of the taxation year (before making any deduction under this paragraph for the taxation year) of property of the class;

(3) Where a taxation year is less than 12 months, the amount allowed as a deduction under this section, other than paragraphs (1)(c), (e), (f) and (g), shall not exceed that proportion of the maximum amount otherwise allowable that the number of days in the taxation year is of 365.

1101. (2a) A separate class is hereby prescribed for each vessel of a taxpayer, including the furniture, fittings, radiocommunications equipment and other equipment attached thereto, in respect of which the Minister of Industry, Trade and Commerce certifies that the vessel

(a) was constructed in Canada;

(b) is registered in Canada; and

(c) had not been used for any purpose whatever before it was acquired by the taxpayer.

1102. (1) The classes of property described in this Part and in Schedule II shall be deemed not to include property

(c) that was not acquired by the taxpayer for the purpose of gaining or producing income;

The plaintiffs were, at all material times, full-time employees of the Government of Canada and performed the duties of their employment in Ottawa. In 1990 both plaintiffs terminated their employment with the public service of Canada. Both are experienced sailboat operators.

On April 27, 1983, the plaintiff Michel DesChênes purchased a steel-hulled vessel known as a Kanter Atlantic 45 Demonstrator bearing serial number ZKN A45 28 0 9 81 for a final purchase price, including extras, of $183,833. The sailboat accommodates up to eight people and is equipped with refrigeration and cooking facilities, making it perfectly suitable for the Caribbean. The purchase was financed with two loans from the Royal Bank of Canada (each in the amount of $65,000 and for which the bank took security in the vessel) and from the proceeds of the sale of the plaintiffs’ house. The plaintiff Michel DesChênes is the registered owner of the vessel, which was named "GOHARA" and registered at the Port of Toronto. At the end of May 1983 the vessel was delivered to the plaintiff Michel DesChênes in Kingston, Ontario, and was issued by the Minister of Regional Industrial Expansion Certificate No. 803,240 pursuant to subsection 1101 (2a) of the Income Tax Regulations.

The plaintiffs, who wanted to rent the sailboat, filed a declaration registered by the Ministry of Consumer and Commercial Relations in Ontario on June 21, 1983, and filed a renewal of the declaration which was registered on August 21, 1989. The declaration stated that the "name of partnership” was "GOHARA CHARTER” and that the "business activity carried on” was BAREBOAT CHARTER". The plaintiffs also entered into agreements with Freedom Yacht Charterers Limited and FreeSpirit Yacht Charterers.

In the years 1983, 1984, 1985, 1986, 1987 and through the fall of 1988, the vessel was docked, sailed and stored in and about Kingston, Ontario, except for parts of 1984 when the vessel was in Quebec. In November 1988, the vessel was sailed to the Caribbean and has been located there even since. The plaintiffs have lived on the vessel year round since August 8, 1990 when they relocated to the Caribbean.

The gross revenue, expenses, capital cost allowance and net income or loss from the boat-chartering operation which the plaintiffs reported in their income tax returns for the 1983, 1984 and 1985 (and subsequent) years (80 per cent of which were claimed by the plaintiff Michel DesChênes and 20 per cent by the plaintiff Ghislaine DesChênes) are shown in the following chart:

[Not reproduced.]

In 1986 and 1987, the defendant, as represented by officials of the Department of National Revenue, conducted an audit of the laintiffs’ income tax returns for 1983 and 1984. The auditor, Peter Belair, met and spoke on the telephone with the plaintiffs and with their accountant, Mr. N. Newton. Mr. Belair reviewed material provided by the plaintiffs and by Mr. Newton.

In 1983, 1984 and 1985, the plaintiffs included in the amount of gross revenues reported on their income tax returns amounts representing the time they sailed without customers aboard. In particular, they included in their gross income for 1983, 1984 and 1985 the amounts of $875, $5,750 and $3,600 respectively for “owners use" of the boat. These amounts were not actually received by the plaintiffs for chartering the boat to third parties. In addition, in filing their income tax returns for the 1983 taxation year, the plaintiffs reduced their expenses by 12 per cent representing a portion attributable to "owner use”. In 1984, the amount of "owner use” was 20 days but in filing their income tax returns for that year, the plaintiffs did not reduce their expenses by 12 per cent. In 1984 and 1985 the plaintiffs deducted all expenses incurred.

By letters dated August 6 and 7, 1986, respectively, Peter Belair advised the plaintiffs that their taxable incomes for 1983 and 1984 were understated by amounts set out in those letters. By letter dated September 30, 1986, the plaintiffs’ accountant wrote to the Department of National Revenue seeking to readjust the plaintiffs’ reported income in a manner that was acceptable to the Department. The accountant sought to remove from reported gross income those amounts of gross income attributable to "owner use” and to reduce expenses by 12 per cent. The Department of National Revenue reassessed the plaintiffs’ 1985 taxation years by notices of reassessment dated November 4, 1986 to effect the changes requested by their accountant.

On January 5, 1987, Mr. Belair advised the plaintiffs that upon review of the income tax returns for 1983, 1984 and 1985 by Revenue Canada's Audit Quality Review Section, “this further review resulted in a change of our opinion regarding the losses claimed in 1983, 1984 and 1985” as there was "no reasonable expectation of profit in those years”.

Prior to the letters of January 5, 1987, no one from the Audit Quality Review Section, or indeed anyone from Revenue Canada, Taxation, aside from Mr. Belair, spoke to the plaintiffs, their accountant or any other representative.

The Minister of National Revenue, by notices of reassessment dated June 5, 1987, reassessed the plaintiff Michel DesChénes by disallowing the following losses claimed with respect to the boat-chartering operation:

The Minister of National Revenue, by notices of reassessment dated June 5, 1987 reassessed the plaintiff Ghislaine DesChênes by disallowing the following losses claimed with respect to the boat-chartering operation:

The Minister of National Revenue reassessed the plaintiffs Michel and Ghislaine DesChênes for the 1983, 1984 and 1985 taxation years on the basis that the charter operation which they conducted did not have a reasonable expectation of profit in any of those years.

The parties admit one of the purposes of the accelerated rate of capital cost allowances was to provide an incentive for the acquisition of Canadian-built boats in order to boost the Canadian boat-building industry.

The basic issue in these appeals is whether the plaintiffs, during their 1983, 1984 and 1985 taxation years, carried on a yacht-chartering business with a reasonable expectation of profit.

Moldowan v. The Queen, [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213, is the leading case as to what constitutes the operation of a business and whether or not a taxpayer can be said to have had a reasonable expectation of profit. The Court sets out the following test of “reasonable expectation of profit" at pages 485-86 (C.T.C. 313-14, D.T.C. 5215):

Although originally disputed, it is now accepted that in order to have a" source of income” the taxpayer must have a profit or reasonable expectation of profit. Source of income, thus, is an equivalent term to business: Dorfman v. M.N.R.,

[1972] C.T.C. 151; 72 D.T.C. 6131. See also paragraph 139(1)(ae) of the Income Tax Act which includes as "personal and living expenses” and therefore not deductible for tax purposes, the expenses of properties maintained by the taxpayer for his own use and benefit, and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit. If the taxpayer in operating his farm is merely indulging in a hobby, with no reasonable expectation of profit, he is disentitled to claim any deduction at all in respect of expenses incurred.

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer's training, the taxpayer's intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive. The factors will differ with the nature and extent of the undertaking: The Queen v. Matthews, [1974] C.T.C. 230; 74 D.T.C. 6193. One would not expect a farmer who purchased a productive going operation to suffer the same start-up losses as the man who begins a tree farm on raw land.

Like my colleague Reed, J. in Coupland v. The Queen, [1988] 1 C.T.C. 414, 88 D.T.C. 6252 (F.C.T.D.) at page 417 (D.T.C. 6254), I am of the view that Moldowan sets out rules which are applicable in all cases, regardless of whether the business under review is farming or of some other type.

Applying the Moldowan test, I can not conclude on the basis of the evidence in this case, that the activities in which the plaintiffs were engaged in 1983, 1984 and 1985, were carried on with a reasonable expectation of a profit. The profit and loss record of the plaintiffs’ business never showed a profit from the first year of its operation, in 1983, to 1989. During those years, while the plaintiffs were working in Ottawa, their yacht-charter operation generated minimal income and suffered consistent losses which, without taking into account the significant capital cost allowance which was claimed for each one of those years, were mainly attributable to high financial costs. During the taxation years in question, when the vessel was financed at approximately two- thirds or its cost, the interest expenses amounted to $38,304.64, while the genuine income totalled only $11,515. In addition, the losses were increased considerably by the substantial amount of capital cost allowance claimed by the plaintiffs for each year ($52,372.31 in 1983, $43,381.80 in 1984 and $61,278 in 1985). In my view, the venture as it was then structured and capitalized had virtually no capability of generating a profit.

lan William Cooke, an individual with some sailing and yacht-chartering experience, testified as an expert witness on behalf of the plaintiffs with regard to financial aspects of yacht-chartering ventures. I must emphasize I was more impressed with Mr. Cooke's experience in maintenance and ground operations than with his expertise on financial operations of yacht-chartering businesses. He expressed the opinion the plaintiffs’ business had a reasonable potential of profitability. However, by reason of Mr. Cooke's candid admission that his definition of” profitability” did not take into account such expenses by boat owners as insurance and capital costs, I am compelled, in the circumstances, not to accept his opinion.

Furthermore, I find that the plaintiffs’ business was not planned and run in such a way as to give rise to a reasonable expectation of profit. The plaintiff Michel DesChênes explained that the long-range plan, after substantial reimbursement of the loans, was to run the yacht-charter operation in Lake Ontario in the summer, and carry on the business in the Caribbean during the winter. He further stated that it turned out it was better to operate down south all year round. Indeed, the boating season is much longer in the Caribbean than in the Lake Ontario region where the boating season runs from May through October each year. The Caribbean market is also considerably more lucrative. In addition, since August 8, 1990, the plaintiffs have been living all year round on their yacht, in the Caribbean, and have been involved full time in their charter operation. In view of the longer boating season and the different market in the Caribbean, and also by reason of the plaintiffs’ full-time involvement in their business since August 8, 1990, I see no resemblance with the charter operation in the Kingston, Quebec and Lake Ontario regions, from 1983 to 1989, where and when the business had no potential profitability. The evidence also shows that the sailboat was never chartered for periods exceeding a total of four weeks in the 1983 and 1984 taxation years, which is equivalent to the time the plaintiffs sailed without customers aboard the same yacht, during the same period of time, and for which they included in their gross income for 1983 and 1984 the amounts of $875 and $5,750 respectively for "owner use” of the boat. With respect to 1985, there is no evidence before the Court of what happened that year with respect to the charter operation, except for the figures filed by the plaintiffs with Revenue Canada. However, these figures suggest that in 1985, as in 1983 and 1984, the sailboat was chartered for similar periods equal to the time the plaintiffs sailed without customers aboard. In my view, such "owner use” of the sailboat, in the circumstances, though alleged to have helped the plaintiffs become more proficient sailing the vessel, actually hindered the charter business more than it helped.

In Chequer v. The Queen, [1988] 1 C.T.C. 257, 88 D.T.C. 6169 (F.C.T.D.) at page 259 (D.T.C. 6170), my colleague Addy, J. stated the following:

There exists a burden of proof on every taxpayer who claims a deduction of net losses resulting from a business adventure, to establish that there was, at the time he engaged in and carried on with the business, a reasonable expectation of profit. The reasonableness of the expectation must be viewed objectively and cannot merely consist of an expectation which the taxpayer in good faith entertains to the effect that a profit will eventually be realized.

Here, in view of all the facts and circumstances shown by the evidence, I am therefore not satisfied that the plaintiffs’ yacht-charter operation as planned, structured and run could give rise to a reasonable expectation of profit for the taxation years in question.

For the reasons given, the plaintiffs’ actions will be dismissed. However, considering the particular circumstances of the further review by Revenue Canada (Audit Quality Review Section), which resulted at the beginning of 1987 in a change of opinion regarding the losses claimed by the plaintiffs in 1983, 1984 and 1985, there will be no adjudication as to costs.

Appeals dismissed.