Date: 20010119
Docket: 2000-990-IT-I
BETWEEN:
DARLENE PELECHATY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
Hershfield, J.
Facts
[1]
Since 1993 the Appellant has undertaken the selling of silk
plants and trees which she acquires under a bonus or commission
arrangement from a supplier carrying on business under the name
Totally Tropical Interiors.
[2]
The Minister of National Revenue ("Minister")
reassessed the Appellant for her 1996 and 1997 taxation years,
disallowing the losses which the Appellant had claimed as
business losses arising from her sales activity. The Appellant
has appealed these reassessments.
[3]
In making the reassessments, the Respondent asserted that the
Appellant had no specific plan on how to increase revenue from
the sales activity, that the sales activity had been suffering
increasing losses since its inception, that there was no
indication that the loss trend could be reversed, that the
Appellant did not have a reasonable expectation of profit during
the subject years and that the sales activity did not constitute
a source of income for the Appellant in the subject years
pursuant to sections 3 and 4 of the Income Tax Act
("the Act"). The Respondent also asserted that
the expenses claimed in relation to the sales activity were
personal or living expenses of the Appellant and, in the
alternative to denying all of the losses for the subject years,
the Respondent submitted that if the Appellant did have a
reasonable expectation of profit from the activity and that if
the activity constituted a source of income, then the losses
should be limited in accordance with a schedule of allowed
expenses set out in the Reply. Disallowed expenses under the
Respondent's alternative position are approximately $2,010.00
in respect of the Appellant's 1996 taxation year and
$5,828.00 in respect of her 1997 taxation year. At the trial, the
Appellant agreed to accept the Respondent's alternative
position including additional income receipts of $1,339.00,
however, the Respondent continued to argue that the losses be
disallowed in their entirety in the subject years on the basis
that the activity giving rise to the losses had no reasonable
expectation of profit.
[4]
The Respondent conceded in the Reply that the Appellant was
sufficiently trained in respect of the sales activity and the
products sold and that she spent sufficient time at the activity,
at least relative to the volume of the business. Indeed, the
uncontradicted evidence of the Appellant is that she spent 15 to
20 hours per week working at some aspect of her silk plant
sales activity. While the Respondent refers to the sales activity
as an "activity", I have no hesitation in referring to
that activity as a business carried on by the Appellant. The
Act defines "business" at subsection 248(1) to
include an "undertaking of any kind" which must be
taken to include, in my view, a sales activity sustained in a
commercial context over a period of years. That is, the
Appellant's undertaking is of a commercial nature and
constitutes a business in my view.
[5]
From 1993 to 1997 the Appellant reported the following income
(losses) from the sale of silk plants and trees:
Taxation
Gross
Net
Year
Income
Expenses
Income (Loss)
1993
$24,216 $27,697 ($3,481)
1994
26,619 34,302 ( 7,683)
1995
19,491 26,279 ( 6,788)
1996
15,062 22,094 ( 7,032)
1997
15,479 24,780 ( 9,301)
The adjusted income under the alternative assessing position
of the Respondent and agreed to by the Appellant is:
Taxation
Gross
Net
Year
Income
Expenses
Income (Loss)
1996
$16,401 $20,084 ($3,683)
1997
15,479 18,952 ( 3,473)
[6]
The start-up of the business in 1993 was simply accomplished by
signing up with Totally Tropical Interiors and by purchasing an
opening inventory of silk plant products. Although the Appellant
had a car for personal use, she acquired a suitable vehicle to
transport her inventory. Home office equipment consisted of a
photocopier. She maintained detailed ledgers of travel and a
daytimer record of appointments and other attendances relating to
the business.
[7]
Gross revenues from the business were commissions paid by Totally
Tropical Interiors. Commissions were based on the Appellant's
personal sales volumes and on the volumes of sales consultants
that the Appellant personally sponsored as commissioned selling
agents for Totally Tropical Interiors. To increase gross
revenues, the Appellant had to increase her personal sales and/or
establish a successful group of personally sponsored sales
consultants. I believe that the Appellant put considerable effort
into the development of the business. In 1993 when she commenced,
she managed to sponsor four consultants, and in 1994 she added
eight more sponsored consultants. Two of the consultants in 1994
had themselves sponsored at least one other consultant and had
achieved monthly sales in excess of $150.00, being a recognized
benchmark in the commission bonus arrangement. In 1995 ten more
consultants were sponsored by the Appellant. In each of 1996 and
1997 only one additional consultant was sponsored by the
Appellant and in each of those two years none of the
Appellant's sponsored consultants had themselves sponsored
additional consultants. Cumulatively, between 1993 and 1997, the
Appellant had 24 sponsored consultants. However, as the
above sales figures indicate (paragraph 5), the cumulative number
of sponsored consultants did not make the business successful.
Most of the Appellant's consultants were not actively
involved in sales. For example, even in 1994, the highest gross
revenue year, the Appellant acknowledged that, of the 12
sponsored consultants on her list at the time, only two were very
active, one was modestly active and the rest were virtually
inactive. Still, by the end of 1994, with only two very active
consultants, the prospects may have looked promising,
particularly if expenses declined (as they in fact did). Further,
in that year, the Appellant reached "Branch Manager"
status. If she could have sustained herself at that level, or
advanced further, commissions would have been enhanced so, again,
prospects may have looked promising.
[8]
The Appellant testified that although she had initially thought
that she could earn $500.00 per month in commissions exclusive of
her efforts, she acknowledged that she had not been successful.
With hindsight and an objective analysis of the commission
structure, this seems like a difficult objective to achieve but
not wholly unreasonable. In 1996 the Appellant had at least six
sponsored consultants who were somewhat active according to
commission records of Totally Tropical Interiors (exhibit A-4).
In 1997 the additional sponsored consultant seemed somewhat
active as well but commissions from consultants grew in 1997 to
only $1,605.00 from $1,339.00 in 1996. To achieve her objective,
her sponsored consultants would have to have done more than three
times the volume done by her sponsored consultants in 1997.
[9]
In 1997 the Appellant focused on increasing her personal sales in
an attempt to generate a profit from the sales business. She
testified that in 1996 she personally did 27 home demonstrations
which she increased in 1997 to 39 home demonstrations. In spite
of her increased personal efforts, sales dropped. She testified
that her home demonstrations are in a farming community and that
her sales reflect the general economic downturn. While home
demonstrations were the main sales focus (implemented by
arranging for hostesses to invite friends to the demonstration),
the Appellant did actively pursue sales to commercial enterprises
as a further means of increasing her sales. The Appellant
acknowledges that she was unsuccessful in this attempt to
establish commercial accounts given that most commercial
enterprises were being serviced from major suppliers in major
centres such as Vancouver.
[10] There is
considerable evidence that the Appellant made every effort to
make a viable business out of the sale of Totally Tropical
Interiors silk products. She actively and I think aggressively
recruited sales consultants and made persistent efforts to train
them and encourage their sales activities. Through advertising
and promotions she was even successful in sponsoring a consultant
in Ontario. She attended training sessions in Regina and
travelled extensively in her area promoting her business. There
is no doubt that she treated this as a commercial activity.
[11] There was
no personal element in these undertakings. While the
Appellant's concession to accept the Respondent's
alternative position may suggest some acceptance that some
expenses were personal, I find this not to be the case, at least
not in any material way. Expenses that are frequently associated
with having a personal element were modest. For example, in 1996
and 1997 meals and entertainment claimed were $110.00 and $322.00
respectively. Expenses disallowed as per the alternative
reassessing position (and agreed to by the Appellant) would
appear more in the nature of what were asserted by Revenue to be
unproven expenses and unreasonable vehicle expenses relating to
miles travelled for business.
Analysis
[12] The basis
for the reassessments under appeal is set out in paragraph 2
above. In particular, the Respondent relies on the assertions
that the Appellant did not have a reasonable expectation of
profit during the subject years from the her sales activities and
that such sales activities did not constitute a source of income
for the Appellant in the subject years.
[13] I have
reviewed the common law reasonable expectation of profit test
applied in Moldowan v. The Queen[1] to hobby farmers to deny losses and
its companion test, that asks whether the activity generating the
loss is a source of income. In that review I found that it can be
worthwhile to look at these tests separately. The source of
income test comes down simply, in my view, to a determination as
to whether there is a genuine commercial enterprise. That is, is
the activity pursued in a systematic, organized, business-like
manner with a genuine profit-making motive?[2] If a genuine commercial enterprise
does not exist, the courts have recognized the absence of a
"source" and neither gains or losses from the activity
are recognized. An example of an activity where the relevance of
the degree of organization is critical in determining whether a
source exists is gambling. Until such activity reaches a certain
point of organized pursuit of profit, incomes and losses are
simply not part of our taxation system.[3] If an activity is a genuine
commercial enterprise, then incomes and losses are recognized as
prescribed by the Act.[4] In Walls et al. v. The Queen (under
appeal to the Supreme Court of Canada),[5] the Federal Court of Appeal found
that unless there is something more to consider such as a
personal element,[6] an ongoing commercial business is not subject to the
reasonable expectation of profit test.
[14] Even
where an activity is found to be a genuine commercial enterprise
and thereby a source of income, there has still been increasing
resort to the reasonable expectation of profit test to deny
losses where the enterprise in question has persistently incurred
losses and threatens to continue to do so. While my review of the
reasonable expectation of profit test has not convinced me that
its application to deny losses to genuine commercial enterprises
can be supported within the scheme of the Act, there is a
body of common law that does apply it.
[15] While the
general rule in Walls is preferable, in my view, another
approach as to when to apply the reasonable expectation of profit
test, even where a genuine commercial activity exists, is
described in the case of Kuhlmann et al. v. The Queen.[7] The Federal
Court of Appeal in that case said, in effect, that, in respect of
a bona fide business, the reasonable expectation of profit
test would not be employed to deny a loss unless the expectation
(that is, the profit motive) is "irrational, absurd and
ridiculous".
[16] In
applying the test in this way, the Court accepted the description
of the test in The Queen v. Matthews[8] at 6196:
I think it most unlikely that he would be engaged in
"tree farming" if it were not for his abiding interest
in forestry but I am convinced that he is bona fide
engaged in it as a business, in the ordinary sense of that word,
with the intention that it be profitable.
[17] Applying
the test in this way is, in my view, also consistent with
applying it "sparingly" or "less
assiduously"[9] where there is no material personal element in respect
of the conduct of the activity. Personal elements such as the
abiding interest in the activity would not, in themselves, be
material for the purpose of applying the test in this way.
[18] Before
resorting to the reasonable expectation of profit test, the Court
should also be satisfied that the income inclusions and more
particularly the expense deductions claimed by a taxpayer in the
creation of a loss, have been carefully scrutinized. While one
would assume that this goes without saying, detailed expense
audits in loss cases where the reasonable expectation of profit
doctrine is applied, do not always happen. In reasonable
expectation of profit cases there may be the temptation, if not a
tendency, to accept losses as filed since expenses (to the extent
of losses) will be denied if that test is successfully applied
and will be so denied without a detailed analysis as to the
appropriateness of particular expenses. The focus is shifted from
considering the appropriateness of a particular expense to
considering the profitability of the business as a whole as
filed. In order to analyse the profit potential of a
business, to the extent that it is ever appropriate to do so,
such analysis can only be properly pursued if the income or loss
determinations have been appropriately determined. In this case,
an audit of expenses was done and I commend the officer of the
Respondent that saw the need to do so.
Conclusion
[19] In the
case at hand, I find that although the Appellant incurred
persistent losses, she was engaged in a genuine commercial
activity with a genuine profit motive. She was engaged in a
business, a "source" included in section 3 of the
Act. Even though revenues declined in the subject years,
her efforts to enhance sales actually increased. I have found
that there was no material personal element in respect of the
activity. An audit has been completed and adjustments to
allowable expenses have been made and agreed to by the Appellant.
Based on these findings and on the Walls decision, I find
that the reasonable expectation of profit test does not apply.
Since Walls is under appeal, I will go further. Based on
the evidence before me and the Appellant's efforts in the
subject years, I find the facts here do not support a finding
that the Appellant's intended purpose and expectation to
profit from the business was irrational, absurd or ridiculous. As
such, I am satisfied that the reasonable expectation of profit
test, to the extent it applies here at all, has been
satisfied.
[20] The
appeals are allowed and are referred back to the Minister of
National Revenue for reconsideration and reassessment to
recalculate the tax liability of the Appellant in each of the
subject years on the basis that the Appellant's revised
losses in each of the subject years are as follows:
1996 - $3,683.00
1997 - $3,473.00
[21] Given
that the Appellant agreed to the Respondent's alternative
position and given that the alternative position has prevailed,
the appeal was essentially successful and on that basis costs are
awarded to the Appellant.
Signed at Ottawa, Canada, this 19th day of January 2001.
"J.E. Hershfield"
J.T.C.C.
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