Gagnon v. R., 99 DTC 845, [1999] 4 CTC 2426 (TCC)

Bowman T.C.J.:

These appeals were heard together. They involve the deduction of expenses paid by the appellants in the 1990, 1991 and 1992 taxation years in connection with a venture engaged in by them with three companies, Ka- notta R & D Corporation (“Kanotta”), Pop Media Ltd. (“Pop Media”) and Online Applications Specific Integrated Solutions Corporation (“O.A.S.LS.”) as well as the recognition of amounts of income received by them from the venture.

Andre Gagnon’s involvement was through a sole proprietorship G.A.G. Software (“G.A.G.”). The involvement of Mrs. Gail Petrie and her late husband, Dr. C. Byron Petrie, in the venture was through a partnership Ryeburn Holdings, in which they were the sole and equal partners. Charles and Gordon Beardsley were involved in the venture as equal partners in a partnership, C & G Systems.

Separate Partial Agreed Statements of Fact were filed for each group of appellants. In broad outline the facts are substantially similar. I shall reproduce only the Partial Agreed Statement of Fact relating to Andre Gagnon as representative. The figures differ somewhat in the case of the Petries (Ryeburn Holdings) and the Beardsleys (C & G Systems).

The Gagnon Partial Agreed Statement of Fact reads as follows:

Partial Agreed Statement of Fact

1. The Appellant, Andre Gagnon is an individual residing at 3 Bracken Crescent, Gloucester, Ontario, Kl J 8N5.

2. At all material times, the Appellant was the proprietor operating under the style G.A.G. Software.

3. The Appellant appeals reassessments dated January 4, 1994, by the Minister of National Revenue under the Income Tax Act for the taxation years 1990, 1991 and 1992.

4. The Appellant filed Notices of Objection within the time limitations of the Income Tax Act.

5. By Notification of Confirmation dated July 14, 1997, the Minister of National Revenue confirmed the reassessments.

6. Pursuant to a written Agreement dated December 21, 1988, G.A.G. Software paid Kanotta R & D Corporation (Kanotta) $46,000.00 and $60,000.00 for a total of $106,000.00 for research material and services more specifically set out in the Agreement.

7. On December 23, 1988, G.A.G. Software entered into a written asset purchase agreement with Online Applications Specific Integrated Solutions Corporation (O.A.S.l.S.) whereby G.A.G. Software purchased for $40,000.00 certain software and related technical assistance as set out in the said agreement.

8. By a written Licence Agreement dated December 28, 1988, G.A.G. Software licenced the applications software for use by Pop Media Ltd. in Canada and the United States of America until December 31, 1994. The Agreement provided for Pop Media Ltd. to pay G.A.G. Software on January 31 st in each year commencing on January 31, 1989, and ending on January 31, 1994, a licencing fee in an amount equal to $20.00 per unit utilizing the applications software during the preceding year subject to a minimum payment of $20,000.00 per annum.

9. At the time of the closing of the licensing transaction, Pop Media Ltd. paid G.A.G. Software $100,000.00 on terms more specifically set out in the said agreement.

10. The Appellant included as gross revenue for each of the taxation years 1989, 1990, 1991, 1992 and 1993 an amount of $20,000.00 per annum representing the minimum royalty payments for each year to G.A.G. Software.

11. By Notice of Reassessment dated January 4, 1994, the Minister increased the gross revenue from the Licence Agreement dated December 28, 1988 by $60,000.00 for 1990 and reduced the gross revenue from that Licence Agreement to nil for subsequent years on the basis that the Appellant had disposed of his property by virtue of an amending agreement dated August 9, 1990 and on the basis that the Appellant was not entitled to a reserve pursuant to paragraph 20(1 )(m) of the Income Tax Act.

12. G.A.G. Software entered into a written Agreement dated December 10, 1990, with Kanotta whereby G.A.G. Software paid to Kanotta $70,000.00 and $110,000.00 for a total of $180,000.00 for research material and referral fees as more specifically set out in the said Agreement.

13. G.A.G. Software entered into a written agreement dated December 10, 1990, with Pop Media Ltd. whereby Pop Media Ltd. was licensed to use the software in Mexico and all Latin American countries for point-of- purchase applications until December 31, 1996.

14. Pursuant to this Licence Agreement, Pop Media Ltd. was required to pay G.A.G. Software a licensing fee of $50.00 per unit utilising G.A.G. Software software, subject to a minimum payment of $44,000.00 for the period January 31, 1991, to December 31, 1992, half of which was to be paid in each year.

15. In order partially to finance this purchase from Kanotta, G.A.G. Software borrowed $126,000.00 from 888258 Ontario Ltd. This loan was secured by the following:

(a) assignment of the Appellant’s right to the minimum annual payment pursuant to the second License Agreement;

(b) pledge of the Appellant’s preferred shares of Pop Media Ltd.;

and

(c) Promissory Note executed by the Appellant, bearing interest at 15.75%.

16. The Appellant claimed as an expense in 1990 an amount of $ 180,000.00 being the amount paid to Kanotta.

17. By a written Agreement dated August 9, 1990, G.A.G. Software and Pop Media Ltd. amended the 1988 Licence Agreement in terms more specifically set out therein.

18. By a written Agreement dated April 15, 1991, G.A.G. Software and Pop Media Ltd. amended the 1990 Licence Agreement in terms more specifically set out therein.

19. On May 3, 1991, G.A.G. Software entered into an Agreement with Pop Media Ltd. whereby G.A.G. Software paid to Pop Media Ltd. $290,000.00 for market development costs associated with the commercial exploitation of the application software and granted to Pop Media a license to use the software in the Mexico City subway system until May 3, 1997.

20. In order partially to finance the said transaction with Pop Media Ltd., G.A.G. Software initially obtained a loan in the amount of $265,000.00 from 888258 Ontario Ltd. Subsequently, the Appellant made payments on January 18, 1992, February 18, 1992, and March 18, 1992, totalling $65,000.00 and so reduced the indebtedness to $200,000.00.

21. In 1991 the Appellant claimed as an expense $290,000.00 paid to Pop Media Ltd. and $19,845.00 for interest paid by G.A.G. Software to 888258 Ontario Ltd. in that year.

22. In 1992, the Appellant claimed an expense in the amount of $55,052.00 for interest paid by G.A.G. Software to 888258 Ontario Ltd. in that year.

Originally, there were two broad issues (the figures relate to Mr. Gagnon):

(a) the deductibility of the amounts of $70,000 and $110,000 paid by Mr. Gagnon to Kanotta in 1990 and the amount of $290,000 paid in 1991 to Pop Media and the deductibility of the interest of $19,855 and $55,052 paid to 888258 Ontario Ltd. in 1991 and 1992 respectively;

(b) the treatment of the sum of $100,000 received by G.A.G. in 1988.

I can deal with the second issue fairly quickly, because it was disposed of on consent, albeit in a somewhat peculiar way. The appellants originally reported the $100,000 over 5 years, under paragraph 12(1)(/), 1989, 1990, 1991, 1992 and 1993, or $20,000 each year, on the basis that they were entitled to a reserve under paragraph 20(1)(m). The Minister of National Revenue accepted the reporting of the $20,000 in 1989, but for 1990 included in income not only the $20,000 reported for that year, but also a further $60,000 that the appellants had reported in 1991, 1992 and 1993. The theory upon which the additional $60,000 was included in 1990 was never made particularly clear, although the Crown did take the position that the $100,000 received in 1988 was income from property and not a business and that the appellants were not entitled to a reserve under paragraph 20(1)(m). The appellants countered with the argument that if the $100,000 was income from property and not a business it should all have been included in 1988 which, as it happens, was a statute-barred year. The Crown, perceiving the precarious position it had put itself in, decided to make the best of a bad situation and filed a consent at the opening of trial, which reads as follows:

Consent to Judgment

The Respondent consents to the Tax Court of Canada disposing of these appeals for the 1990, 1991 and 1992 taxation years by allowing them and by referring the reassessments back to the Minister of National Revenue for reconsideration and reassessment on the basis that the income received by the Appellants as a result of the licensing agreements entered into with PopMedia Ltd. in December 1988, was earned over the life of those agreements, as originally reported by the Appellants in their income tax returns.

Counsel for the appellants never signed the consent, but treated it as an admission that the appellants were carrying on a business because it was only on the basis that they were carrying on a business that the $100,000 could be spread over five years under paragraphs 12(1)(/) and 20 (1)(m). The wording of the consent is a little strange, and is apparently designed to avoid any admission that a business was being carried on. [1]

In any event counsel for the appellants decided to accept the treatment consented to by the respondent and so the preliminary tactical skirmish was resolved. It should however be noted in passing that to spread a payment of an income nature that has been received in one year over five years requires statutory authority. It cannot be done on the basis set out in the “Consent to Judgment” that it was “earned over the life of those agreements”. Such a basis is legally and factually incorrect: paragraph 12(1)(a) of the Income Tax Act; Ikea Ltd. v. R., [1998] 1 S.C.R. 196 (S.C.C.). The conclusion that I have reached that the $100,000 was income from a business provides that statutory basis under paragraphs 12( I )(/) and 20( I )(m). I am not, however, prepared to accept the so-called consent as an admission that the appellants were carrying on a business. Such a conclusion is one of law (Associated Investors of Canada Ltd. v. Minister of National Revenue (1967), 67 D.T.C. 5096 (Can. Ex. Ct.)) and an admission of law is not binding on the court (L.I.U.N.A., Local 527 Members Training Trust Fund v. R. (1992), 92 D.T.C. 2365 (T.C.C.). I have concluded independently that the income which the appellants received or anticipated was income from a business.

I come now to the main issue — the deductibility of the amounts paid by the appellants in 1990 and 1991 and the deduction of interest.

The amounts were in fact paid. In each case they were paid for a particular type of software to be used by Pop Media in connection with an ambitious marketing strategy which it had developed to sell to retailers such as Toys R Us, K Mart Group, 7-Eleven, the Liquor Control Board of Ontario and the Toronto Skydome. The business opportunities were fully and carefully researched. The appellants are all knowledgeable and sophisticated investors. Andre Gagnon is the owner of a chain of gasoline stations. Gail Petrie is a successful lawyer and her late husband was a doctor. The Beardsleys are insurance brokers. The software that formed the basis of the acquisition was in each case a module to be used in connection with the point of purchase marketing strategy to be marketed by Pop Media. In the case of the Beardleys, the module was a self-programming display feature. In the case of Mr. Gagnon, the application software was a device permitting messages to be loaded en masse during off-peak hours and to be selectively displayed at specific times during the week. This software was described as “valid range time”. In the case of the Petries, the applications software was a communications interface that verified that messages displayed were authorized and restricted unauthorized access to the display units. Each of these types of software was necessary to the point of purchase marketing system, which Pop Media was promoting and marketing.

I shall deal with each of the contentions put forward by the respondent. It was argued at some length that the income earned and expected to be earned by the appellants was income from property and that the range of expenses deductible in computing income from property is more restricted than in the case of income from a business. I know of no authority that would justify a more restrictive treatment of expenses relating to the earning of property income. Although it makes no difference to the deductibility of expenses whether the income is from property or from a business, I think the better view is that the income that the appellants earned or anticipated earning is income from a business, as that word is defined in section 248. I might observe in passing that if I accepted the respondent’s argument that the income was from property rather than a business, the $100,000 received in the statute-barred year 1988 would have been taxable in that year and could not be spread over five years under paragraphs 12(1)(/) and 20(1)(m).

There was no suggestion that the amounts expended were on capital account, but the respondent argued that they were not laid out for the purpose of gaining or producing income from property or a business. I fail to see how they could not have been. What we have here, pure and simple, is a risky, audacious and imaginative undertaking. The sole purpose of the expenditures was the earning of substantial income. Even discounting to some degree the somewhat sanguine financial predictions of Mr. Eric Hutchingame, a consummate salesman who projected an air of enthusiasm, optimism and competence, the appellants had every reason to believe that substantial profits would be earned. Examples of this are the letter of October 5, 1990 to the Beardleys, the letters of October 5, 1991 and February 26, 1991 to Mr. Gagnon, or the Status Report of February 15, 1990 (Petrie Book of Documents, Exhibit A-10, Tab 16), or the Report to Shareholders of March 28, 1990 (Tab 19), to mention only a few.

I find as a fact that the appellants all embarked on the venture in the reasonable expectation that it could yield significant profits. This was based in part on a favourable report from Nielsen Marketing Research as well as the substantial volume of other material supplied to the appellants and meetings with Mr. Baker and Mr. Hutchingame of Pop Media. The subsequent expenditures were equally carefully researched. It must be recognized that although the enterprise was risky, the field of high tech software is a burgeoning one and had the enterprise met even a portion of the projections of the chairman of Pop Media, Mr. William Baker, and Mr. Eric Hutchingame, it would have made the appellants millionaires. Indeed the faith of the appellants Gagnon and the Petries in the venture is confirmed by their further subscription for shares. I am not oblivious to the fact that it was believed that an IPO was in the offing, but for a number of reasons it did not materialize. Nonetheless, it was a part of the commercial venture in which the appellants were engaged.

So far as the suggestion that the amounts paid were unreasonable is concerned, the evidence simply does not support that conclusion. The costs of developing the software in fact exceeded the price at which it was sold. The cost of promoting and developing the market in the United States, Canada and Mexico was substantial. Expenses are not unreasonable simply because they are substantial. Here, they were commensurate with the anticipated returns. For an expense to be unreasonable it must, based upon objective criteria and comparison, be one that a reasonable businessperson would not have incurred having in mind only the commercial advantage sought, (Gabco Ltd. v. Minister of National Revenue (1968), 68 D.T.C. 5210 (Can. Ex. Ct.)).

This case in my opinion is a striking example of the Minister second- guessing the business acumen and judgment of experienced and intelligent businesspersons.

In Nichol v. R. (1993), 93 D.T.C. 1216 (T.C.C.) at 1219 , I said:

[Mr. Nichol] made what might, in retrospect, be seen as an error in judgment but it was a matter of business judgment and it was not one so patently unreasonable as to entitle this Court or the Minister of National Revenue to substitute its or his judgment for it, or penalize him for having made a judgment call that, with the benefit of 20-20 hindsight, that Monday morning quarterbacks always have, 1 or the Minister of National Revenue might not make today. We were, after all, not there in 1986.

This statement was approved in Tonn v. R. (1995), 96 D.T.C. 6001 (Fed. C.A.), except for the word “patently”.

The respondent, in support of the proposition that the payments were not made, relies upon the fact that the payments were made with money borrowed through non-recourse loans from 888258 Ontario Ltd. secured by an assignment of the appellants’ shares. This fact in my view is irrelevant. The money was borrowed and paid. Had the venture been as successful as anticipated it would have been repaid. The fact that the lender subsequently took over the security may have consequences under section 79 or section 80, but that has nothing to do with the issue before me in these cases.

The final point made by the respondent is that “the transactions were a scheme, the sole purpose of which was to enable the Appellant[s] to receive an income tax refund in excess of [their] actual cash outlay...”.

The argument is without merit. It was not the appellants’ purpose at all. Even mathematically it is wrong. It completely ignores the solid commercial basis upon which the expenditures were made. It is unsupported conjecture and moreover it makes no economic sense. No rational person spends $100 to obtain a tax advantage of $54. That is neither tax avoidance nor tax planning. It is fiscal foolishness — something that I am not prepared to ascribe to these appellants.

The argument that there was no reasonable expectation of profit, although mentioned in the pleadings, was not pursued with any degree of vigour by counsel for the respondent. The “no reasonable expectation of profit” doctrine has no application to a carefully researched albeit risky business venture of the type we have here. This is, unfortunately, an example of a case where, if a business fails, the Minister, with 20-20 hindsight, ritually intones “no reasonable expectation of profit”, but if the same business succeeds or earns money, the Minister demands his share of the profit.

The appeals are allowed and the assessments are referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with these reasons and with the document filed by the respondent entitled “Consent to Judgment”. Counsel requested that I defer issuing judgment until they have had an opportunity of addressing the question of costs. Counsel are invited to communicate with the court to arrange a suitable date for doing so. If counsel wish the matter can be dealt with by telephone conference call.

Appeals allowed.

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