Engler v. The Queen, 94 DTC 6280, [1994] 2 CTC 64 (FCTD)

Joyal, J.:—The Court is seized of three appeals by way of statements of claim from reassessments made by the Minister of National Revenue for each of the years 1984, 1985 and 1986.

The issue between the parties is to determine whether or not certain expenses incurred by the plaintiff in each of these years were for the purpose of producing income from a business within the meaning of paragraph 18(1 )(a) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). The Minister reassessed the plaintiff on the grounds that the business against which the expenses were claimed had no reasonable expectation of profit and the expenses should therefore be disallowed. Such a situation often faces this Court when the losses of the business are charged against a taxpayer's other income.

The evidence

The plaintiff's testimony at trial, as well as supporting documents filed here and below, provide the picture of a taxpayer who throughout his working life exer- cised varied entrepreneurial skills in several ventures requiring an impressive amount of energy on his part. During his working years as a member of the Canadian Armed Forces and later as catering superintendent for the British Columbia Ferry Corp., he managed to get into a number of side businesses which he explained to the Court were not of the cottage-industry variety, but rather the result of careful planning, good marketing surveys and proper income projections and budgets.

He testified that as he approached mandatory retirement age with B.C. Ferry, he had in mind "establishing" a sound family business to supplement whatever military pension and employer retirement benefits to which he would become entitled. Accordingly, he had formed the Corym Marketing Co. in 1981 to buy and sell various gift items such as brassware, watches, rings and household gadgets. In the years 1982 and 1983, he had managed to make a small profit of some $400 and $700.

At about the same time, the plaintiff became involved in another venture called Richville Enterprises Ltd. to provide mail distribution, parcel and photocopy services and other commercial services to the general public. This venture occupied most of the plaintiff's spare time and well it should have, for the plaintiff succeeded well and realized a handsome profit or gain when he disposed of the company in 1984.

In the meantime, Corym, duly looked after by the plaintiff's spouse, had remained fairly dormant. Upon the sale of Richville, however, the plaintiff reapplied his mind to the Corym business. He explained in his evidence that certain unforeseen market problems developed. In 1984, having decided to market high quality expensive toys imported from Germany, he found his customers favouring far less expensive toys imported from the Far East. He stated that he thereby suffered a very high inventory loss.

In 1985, he began to carry other toys as well as jewellery and novelties. The competition was very stiff, said the plaintiff, and in spite of advertising in British Columbia, California, Nevada and other parts of the United States, he suffered even greater losses.

The plaintiff further stated that in 1986, he ventured into clothing purchased in bulk from Toronto. Although this was a successful venture, it did not make up for the slow market in jewellery, novelties and other wares. Again, he suffered considerable losses.

In the tax returns for the years under dispute, namely 1984, 1985 and 1986, the plaintiff disclosed Corym's profit and loss situation as follows:

A third set of calculations was made when the defendant, in its continuing audit, reassessed the plaintiff for each of the years 1984, 1985 and 1986. The defendant took the position that many of the expenses claimed were not business but purely personal expenses. More than that, the defendant denied all of the expenses on grounds that the business against which the expenses were claimed did not, during that three-year period, have a reasonable expectation of profit.

Finally, sometime before trial in this Court, the parties filed an agreed statement of profit and loss as follows:

The evidence indicates that whatever tax adjustments might have been required based on the losses as claimed by the plaintiff, the parties have agreed that it is on the basis of the agreed bottom line figure as disclosed above that final reassessments, one way or the other, for each of the taxation years are to be determined.

The law and jurisprudence

The Income Tax Act, in paragraph 18(1 )(a), makes it quite clear that no expenses are allowed except those incurred for the purpose of gaining or producing income from a business property. Similarly, section 4 of the Act, in establishing the "sourcing" or “matching” principle in the determination of any income or loss, limits considerably the more imaginative ways in which a taxpayer may lump all his income from all sources and deduct all his expenses from these sources and consolidate his return accordingly. Each business as a source of income has its own identity, so to speak, even though any one or more of such businesses may be run by the same taxpayer.

In any event, it is not a matter of dispute that the test of “reasonable expectation of profit" applies to such businesses. Normally, a business loss will not be the subject of scrutiny by Revenue Canada when such a business is the only source of income. Even a series of annual losses will not often be questioned should the taxpayer wish to continue absorbing the losses. It is only when the taxpayer has other sources of income against which any such losses are claimed that Revenue Canada’s antennae start sending out signals which might become a source of concern to the taxpayer. Depending on the circumstances in each case, Revenue Canada will assume that the taxpayer is engaged in a business which objectively has no reasonable expectation of profit. The inference will be drawn that the taxpayer is merely engaged in a sport, hobby or some other self-satisfying endeavour, and if his losses are charged to his other sources of income, he is effectively reducing his tax exposure. As Brûlé, J.T.C.C. said in the Court below, this means that other taxpayers are picking up the losses.

Such an assumption by Revenue Canada should nevertheless be based on objective criteria, and many elements in any business operation must be analyzed or scrutinized before such an assumption may be made. These elements or criteria were very ably categorized by the Supreme Court of Canada in the often-quoted case of Moldowan v. The Queen, [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213 at pages 485-86 (C.T.C. 313-14, D.T.C. 5215), where Dickson, J., as he then was, propounded the following:

Although originally disputed, it is now accepted that in order to have a "source of income” the taxpayer must have a profit or a reasonable expectation of profit. Source of income, thus, is an equivalent term of business: Dorfman v. M.N.R., [1972] C.T.C. 151, 72 D.T.C. 6131. See also 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 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 oe 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.

Admittedly, the above statement was in relation to farm losses under section 13 (now section 31) of the Act, which provides for a more elaborate formula in determining farm losses in particular. Nevertheless, the criteria set out by Dickson, J. have since been universally accepted and followed. As stated by Dickson, J., the test of reasonable expectation of profit is an objective test.

In this connection, the Court must nevertheless keep in mind a statement in the Federal Court by Mahoney, J. (now Mahoney, J.A.) in The Queen v. Matthews, [1974] C.T.C. 230, 74 D.T.C. 6193, at 236, (D.T.C. 6197) as follows:

It is important to note that. . .the word "reasonable" modifies "expectation", not "profit", and that the term “reasonable expectation of profit" is not synonymous with the term “expectation of reasonable profit".

I take this to mean that although a profit, expressed in percentage terms as a return on investment, or on energy and time and effort expended, might not be of a nature to invite a take-over bid (as it did with Richville), the test of reasonableness is met if a profit has been realized.

I should further observe that although one must subscribe to the doctrine of objectivity in its application, the test is necessarily ex post facto and is simply an acknowledgement that the reasonable expectation, which the taxpayer will always fervently advance, subsequently turned out to be unreasonable.

There is a kind of Monday morning quarterback judgment call here which, although perfectly in accordance with the legal principle, does not consider the human element involved whenever a taxpayer ventures into any kind of small business as a sideline and charges off his losses against his other income. What would otherwise be his ability to charge off his losses against other income does not mean that the taxpayer is in a win-win situation and no loss is sustained. He must still absorb anywhere up to half of his losses and his net after-tax income is reduced accordingly. Common sense would lead one to suggest that this is a constraint on a taxpayer's free flow of hope and imagination, and might constitute a factor in the final equation.

Yet, should this be a relevant factor, other factors also have to be applied, i.e., the nature of the expenses (i.e., salary to spouse or children, percentage costs of home expenses such as taxes, insurance and other similar charges) which in the end, might mean that although the taxpayer's after-tax income is reduced, his personal expenses or his cost of living are proportionately reduced. In effect, the taxpayer is getting a free ride, a privilege which the Income Tax Act does not normally intend to provide.

Findings

I am satisfied on the evidence before me that the plaintiff is a serious and well- regarded citizen who after enjoying two successful careers and the perks that go with them, wished to develop some sideline business to supplement the retirement income he would be entitled to upon retirement from the B.C. Ferry Corp. When he established Corym in 1981, the appellant’s major sources of income consisted of a salary of some $57,000 and an army pension of some $8,000. Employed full-time by the B.C. Ferry Corp. and busy as well with other paraprofessional responsibilities, he could obviously devote only limited time to the Corym operation. In 1983, he had sales of $1,357 on which he realized a gross profit of $1,230. The expenses claimed for that year totalled $492 and he realized a net profit of $738.

In 1984, his original statement of income and expenses showed an increase in sales to $3,674 with a marginal gross profit of $103. Against this, he attributed a total of $15,818 in expenses. No one can deny the fact that the ratio of sales to losses is extremely wide and the expenses attributed by the plaintiff to the operation has increased to an unconscionable level.

The same phenomenon was repeated in 1985 where on sales of $6,063 and a gross profit or $334, he claimed expenses in excess of $21,300.

In 1986, on sales of $10,717 and a gross profit of $3,873, he claimed net losses of $22,921.

It is also in evidence that losses of $12,388 and $7,961 were claimed in 1987 and 1988 respectively.

These losses, as claimed, do not of course reflect accurately the extent to which Corym's actual losses may be measured. Later statements were produced where many expense items were reduced or eliminated, with losses consequently reduced to $6,516 for 1984, $16,744 for 1985 and $16,957 for 1986. The inference is clear that the original claimed expenses had been grossly overstated or were not business expenses at all.

When, for purposes of the trial before me, the parties agreed to a more accurate accounting of sales, gross profits and properly allowed expenses incurred, Corym still showed losses of $3,654 for 1984, $10,921 for 1985 and $11,431 for 1986.

I should find that these figures speak for themselves. In the final breakdown, gross profits for each taxation year were marginal and remained so throughout as a proportion of total sales.

The same may be said of the profits and losses in 1987 and 1988, as disclosed in the plaintiff's original statement, and which is further evidence of an unprofitable operation. Certain it is that, generally speaking, the whole financial experience falls short of the criteria set out in the Moldowan case, supra, and any number of cases since. It may be said that notwithstanding the plaintiff’s efforts at rationalizing the losses incurred, Corym did not have, objectively speaking, a reasonable expectation of profit. Perhaps this finding might be better expressed by stating that on the evidence before me, the plaintiff has not succeeded in rebutting the assumption of fact on which the defendant relied in issuing the reassessments.

I should, however, add a qualifier to this finding. It is in evidence that in 1983, Corym did enjoy a small profit. No doubt, this was partly by reason of the plaintiff applying, against his profit for that year and presumably the previous year, certain expenses which may be said to be on the lean side and certainly more proportionate to Corym's volume of business and the scope of its operations generally. Nevertheless, a profit was realized.

It is also in evidence that in 1983 and 1984, the plaintiff was involved in the Richville venture and thus unable to spend whatever spare time he had available to improve the Corym business. The running of it was left to the plaintiff's spouse. When Richville was sold, however, the plaintiff renewed or redirected his activities and efforts to the Corym operations. His evidence indicates the various steps he took to enhance the volume of business and the potential return.

It has been said, in the context of farm losses, as in the Moldowan case, supra, that the reasonable expectation of profit cannot be objectively determined a priori. No one is a crystal-ball gazer able to determine the actual results of any business endeavour. That is why the precedents cited by counsel for the parties, including of course the Moldowan case, as well as Speck v. M.N.R., [1988] 2 C.T.C. 2133, 88 D.T.C. 1518 (T.C.C.), Zavitz v. M.N.R., [1978] C.T.C. 3021, 78 D.T.C. 1730 (T.R.B.), and Coupland v. The Queen, [1988] 1 C.T.C. 414, 88 D.T.C. 6252 (F.C.T.D.), suggest that a history of profitable operations, both before and after one or more taxation year, has to be considered in the determining of a reasonable expectation of profit.

In the case before me, I must give some weight to the fact that Corym's operations in 1982 and 1983 were profitable. They were profitable even though its owner was otherwise preoccupied, not only with B.C. Ferry Corp, but also with Richville. Upon once more directing his attention to the Corym business in 1984, he had of course the experience of profitable operations in the two previous years. There would have been little doubt in anyone's mind that by extending the variety of wares offered for sale, or by greater promotion, or by devoting more time to the Corym operations, a small but continuing profit could be reasonably expected. Therefore, I should find that for the year 1984, the business did have a reasonable expectation of profit, that the defendant's reassessment for that year should be vacated, and that the loss sustained in the agreed statement of profit and loss for that year should be allowed.

Conclusions

In so ruling, I am of course aware that the story before me involves the conjugation of two different income tax issues, namely the determination of the allowable expenses charged by the plaintiff against Corym's income and the determination as to whether or not any expense should be allowed at all. On the evidence, it might be said that the plaintiff originally brought the whole controversy upon himself by claiming expenses which could not by any stretch of the imagination be justified. In the face of this obvious disproportion between the resulting losses and the volume of business generated, or the capital committed, or the time and energy devoted to it, it was an easy slide from a determination of the unreasonableness of the expenses to an assumption that the venture, in any event, did not have a reasonable expectation of profit.

I am of the view that the two processes, for tax purposes, are separate and distinct. What the Court is asked to determine is not the reasonableness of the expenses claimed, but the reasonableness of any expectation of profit for the years in question. For the reasons stated, I should allow the plaintiff's appeal with respect to the 1984 reassessment, but otherwise confirm the defendant's reassessments for the two following years.

The plaintiff is entitled to his costs.

Appeal allowed in part.