Petrovic v. The Queen, docket 97-3401-IT-G

Date: 20000130

Docket: 97-3401-IT-G

BETWEEN:

MIOMIR PETROVIC,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Lamarre, J.T.C.C.

[1]            These are appeals from assessments made by the Minister of National Revenue ("Minister") under the Income Tax Act ("Act"), whereby the Minister disallowed net losses claimed by the appellant in the amounts of $38,615.49, $43,698.02 and $39,033.39 for each of the 1993, 1994 and 1995 taxation years respectively with respect to the carrying on of an activity by the appellant under the name of Jackie's Fashion Design ("Jackie").

[2]            The facts agreed upon by the parties are reproduced in an Agreed Statement of Facts and read as follows:

1.              The Appellant at all material times operated an activity involving the design, manufacture and sale of jewellery, hair accessories and some clothing, under the name Jackie's Fashion Design (the "Activity"). The Appellant commenced the Activity in 1987.

2.              In addition, the Appellant was at all material times employed full-time at Bell Northern Research, now known as Nortel Networks Corporation.

3.              The Appellant's spouse was at all material times engaged full-time in the Activity.

4.              The base of operations for the Activity was located in the residence of the Appellant and his spouse.

5.              The Appellant maintained books and records for the Activity.

6.              The merchandise produced by the Activity was sold to a number of retail outlets.

7.              The expenses of the Activity included a management fee paid to the Appellant's spouse.

8.              The Appellant's spouse reported her receipt of the fee on her T1 tax returns for the applicable years, and paid tax on that income.

9.              In 1989, the Minister of National Revenue (the "Minister") audited the Appellant's 1987 and 1988 tax returns. At the conclusion of the audit, the Appellant was informed that everything was in order.

10.            In filing his T1 income tax returns for the 1987 through 1998 taxation years, the Appellant reported and claimed with respect to the Activity the revenues, expenses, cost of goods sold, net income (loss) and the fee paid to the Appellant's spouse, as set out in Schedule "A", which is appended hereto and incorporated in this Agreed Statement of Facts by reference.* Schedule "A" includes the Appellant's employment income from 1987 to 1998.

11.            During the 1996 taxation year, the Appellant was the subject of another audit by the Minister. Upon completion of the audit, the Minister took the position that the Activity does not have a reasonable expectation of profit, and disallowed the losses which the Appellant claimed in respect of the Activity.

12.            The Minister, by Notices of Reassessment dated September 10, 1996 (the "Reassessments"), reassessed the Appellant's 1993, 1994 and 1995 taxation years to disallow the net loss claimed with respect to the Activity in each of those years.

13.            On December 9, 1996, the Appellant served on the Minister Notices of Objection against the Reassessments.

14.            The Minister, by Notification of Confirmation dated August 19, 1997, confirmed the Reassessments.

To date, the Minister has not reassessed the Appellant's spouse to delete from her income the management fees from the Activity which she had reported as income, and on which she had paid tax.

[3]            The appellant testified that he and his wife Jagoja Petrovic immigrated to Canada from Yugoslavia in July 1986. The appellant graduated in Yugoslavia with a Bachelor of Science in electrical engineering and before coming to Canada was working as director of consumer electronics in a large company. His wife has a bachelor's degree in economics and was working as a fashion designer in her father's fashion design company in Yugoslavia. A year and a half before moving to Canada, she started her own fashion design company, which was mostly a clothing manufacture. She had one or two employees and her business was profitable.

[4]            On their arrival in Canada, the appellant found a job at $20,000 per year. According to schedule A of the Agreed Statement of Facts, his salary increased to $45,000 in 1987 and thereupon raised gradually to a peak of $98,000 in 1996.

[5]            At the same time, the appellant and his wife wanted to start a business like the one operated by Ms. Petrovic in Yugoslavia. According to the appellant, they did a market analysis -- that is, they consulted some friends they had here and some accountants to find out if a clothing manufacturing business would be profitable. They found out, however, that they would be better off starting out in their new country with something easier and they decided to manufacture hair accessories, which would help them build a customer base. In 1988, they started to sell jewellery.

[6]            The main worker in the business was Ms. Petrovic -- she was working 12 hours a day and occasionally on weekends – and, in the first years, she was paid a small salary for her work (between $6,000 and $10,000). At first, they were buying jewellery from wholesalers and reselling them to various boutiques. However, they soon realized that they could not make any profit that way because the profit margin was too low. But, according to the appellant and his wife, they were gradually penetrating the market, which was one goal that had to be achieved in order to make a profit one day.

[7]            After a while, they decided to manufacture their own jewellery to reduce the costs. They thought that that way their markup could be two and a half times their cost, compared to the 10 to 20 percent markup on the resale of jewellery bought from wholesalers.

[8]            By 1990, they had raised their gross revenues to $40,000 but the losses also increased. The appellant testified that at that time they were still selling more jewellery bought from wholesalers, reducing thereby their profit margin. He said that at that point they could have stopped building up their customer base, reduced their costs and lived with $40,000 gross revenue, but then, he said, they had not started the whole process just to stop there.

[9]            In 1991, revenues dropped from $40,000 to $21,000. According to the appellant, the introduction of the goods and services tax ("GST") had an impact on their customers. The appellant had the choice of either closing the business or going ahead with finding more customers. He chose the second option. But, in order to further enlarge their customer base and expand their clientele outside Ottawa, Ms. Petrovic had to do more travelling.

[10]          In 1992, revenues increased to $29,000. According to the appellant, at that time one or two percent of gross revenue was attributable to hair accessories, 20 to 25 percent to the resale of jewellery and the balance to the sale of their own manufactured jewellery.

[11]          In the years at issue (1993 to 1995), sales grew to $45,000. At that time, they were producing their own jewellery and a few items of clothing from their home. The equipment required was minimal (a few sewing machines, irons and a computer room) and they did not keep a large inventory -- Ms. Petrovic was producing on demand. They did not advertise in newspapers or in the yellow pages but held home parties, which involved inviting people to their home and trying to sell their merchandise on these occasions. These home parties did not turn out to be as profitable as they had thought, due to the low average income of their customers who preferred to buy cheaper jewellery from well-known retailers like Winners or Wal-Mart.

[12]          The appellant testified that he financed this jewellery business with his income tax refunds and from his own RRSP savings (approximately $58,000). He used a line of credit of $5,000 for bridge financing, but other than that he did not borrow money to inject into the business. The appellant himself devoted one day a week to the business while his wife worked in it full time. Occasionally, they would hire one or two part-time employees to meet the demand.

[13]          Although revenues increased in the years at issue (to $45,817 in 1994), the losses also increased significantly (from $22,181 in 1992 to $38,615 in 1993 and $43,698 in 1994). The appellant explained these losses by the purchase of a new Honda automobile for his wife in those years and the increase of her salary from $7,000 to $26,690 in 1993, $29,300 in 1994 and $21,552 in 1995. The appellant said that they were now targeting high-end customers and thus had to penetrate other markets than Ottawa. The car was therefore a necessity in order for his wife to travel around in quest of new customers. As for his wife's salary, the appellant testified that at that time she wanted to find a more lucrative job. In order for him to keep the activity going, he had to offer his wife a real salary (which he considered to be still quite low for the work she was doing).

[14]          In that context, the appellant was of the view that they needed to sell approximately $100,000 worth of jewellery per year to become profitable (indeed, in 1993 and 1994, the cost of goods sold and expenses totalled $80,000 to $90,000). This meant, at an average sale price of $10 per item, the sale of approximately 10,000 pieces of jewellery per year. According to him, it was possible to produce that quantity of jewellery with additional workers. Answering a question from his own counsel, the appellant explained that this goal was not reached in those years for several reasons. First, they had to invest in higher quality materials to serve high-end customers (there was therefore a higher cost for new materials) and, in that context, they had to find a completely new niche of high-level boutiques. Second, there was a severe economic recession in those years. A lot of the boutiques buying their stock went bankrupt or went out of business (65 to 70 percent of the boutiques they were dealing with, he estimated).

[15]          To support this assertion, the appellant called Ms. Marlene Shepherd, owner of Shepherd's Fashion Accessories Limited ("Shepherd"), which has been in the business for 21 years. Shepherd is Jackie's main client and they have been dealing with each other for 10 years. Ms. Shepherd said that she was buying $10,000 to $12,000 worth of merchandise from Jackie per year except during the recession years. She said that Jackie's product was very saleable. Ms. Shepherd said that Ms. Petrovic was very professional, that she manufactured products wanted by consumers, that she was able to produce quickly on short notice, that she redesigned her products to meet Shepherd's specifications if necessary, and that she never turned down a customer's order. Ms. Shepherd described Ms. Petrovic as being very aggressive and not giving the impression of being unconcerned about profitability.

[16]          Ms. Shepherd testified that Jackie's products were an important aspect of her fashion jewellery business. She said that she was buying in volume from Jackie at a good price and that, according to Ms. Shepherd, is important in that kind of business.

[17]          Ms. Shepherd said that she used to run three stores but had to close one in 1996 because of the recession. She said that there was a constant turnover of stores that went bankrupt during the 1990s. She testified that Shepherd was not profitable during the 1990s. She faced at least two years of big losses (she lost almost $200,000 in the mid-1990s). In those years, she and her mother had to inject cash of their own and take severe salary cuts. Her reduced salary was roughly between $30,000 and $40,000 per year, although she might work as many as 60 hours a week.

[18]          In cross-examination, Ms. Shepherd stated that from the year she opened her stores in 1978, there had always been a predictable steady increase in sales, which usually resulted in profit. In 1989, however, she started to see sales going down. This continued until 1998. In 1998 and 1999, she again attained the sales figures that she had had in her better years in the 1980s, with a good profit margin.

[19]          In examination-in-chief, the appellant was asked by his counsel why he increased expenditures in the middle of the recession. His answer was that it was difficult to anticipate how long the recession would last. As a lot of their competitors disappeared, they decided to stay in business to keep their high-end customers. He said that every year he made financial projections for the coming year (these were not filed in evidence however) but the market did not perform as anticipated.

[20]          In 1997 and 1998, the activity did not show a loss but made very little profit or none at all (profit was nil in 1997 and $300 in 1998) and the appellant explained that these results were possible because he did not pay a salary to his wife. In fact, he acknowledged that without his wife's salary and without the deduction of business-use-of-home expenses, the activity could have shown a profit.

[21]          The appellant testified that they had not changed their product line over the years but he still believed that he was going to make profit one day because of his and his wife's significant experience. They are now trying to introduce their jewellery on the Internet and they hope to earn a profit from that source.

[22]          In cross-examination, the appellant was shown a business questionnaire filled out by him, in which he indicated that his start-up costs amounted to only $3,400. The appellant explained that they did not buy a large quantity of materials. They would buy the exact quantity necessary for an order placed by a customer. In that same questionnaire the appellant indicated that the time spent on running the business and on promoting and marketing their products could vary between 61 and 92 hours per week, and a great proportion of this time was put in by his wife.

[23]          The statement of business activities filed with the appellant's tax return for the taxation years at issue (Exhibit R-1, Tabs 4, 5 and 6) disclosed the following information:

	1993	1994	1995
Gross income	$ 43,347.58	$ 45,817.04	$ 31,949.94
Cost of goods sold	19,159.72	18,826.02	14,099.52
Gross profit	24,187.86	26,991.02	17,850.42
Expenses
Advertising	1,625.41	3,305.65	2,884.32
Business tax, dues	865.78	1,832.36	0
Insurance	284.40	292.00	267.00
Interest	1,118.49	1,239.00	1,620.29
Maintenance & repairs	244.34	537.55	0
Management fees	29,698.76	29,300.00	21,552.65
Meals & entertainment	1,357.16	1,855.50	1,362.82
Motor vehicle expenses	13,774.09	14,426.22	12,673.18
Office expenses	3,106.16	917.02	2,129.44
Legal, accounting fees	326.48	380.41	581.75
Property taxes	984.91	1,272.34	1,269.47
Rent	0	3,412.49	3,287.33
Supplies	3,125.16	1,100.44	0
Salaries	3,865.52	5,286.80	2,867.00
Travel	1,087.61	1,634.10	1,205.17
Telephone & utilities	0	2,463.43	3,661.21
Capital cost allowance	1,339.08	1,433.73	1,522.18
Total expenses	$62,803.35	$70,689.04	$56,883.81
Net loss	-38,615.49	-43,698.02	-39,033.39

[24]          The appellant testified that the salary paid to his wife was in a very low range. She deserved a much higher salary taking into account her experience and her involvement in the business. All the products are designed by her and she is the one who works closely with customers to keep attuned to new market demands. Indeed, Ms. Petrovic testified that in 1993 she introduced crystal jewellery, which represented a major change in the business. She could take a higher markup on it. In the years at issue, she was selling to 15 major boutiques, Shepherd being her main customer. Out of total sales of $43,663 in 1993, the appellant invoiced $27,519 to Shepherd that year, which means 63 percent of total sales were made to Shepherd; in 1994 that proportion rose to 70 percent and dropped to 50 percent in 1995 (see Exhibit R-1, Tab 3). Ms. Petrovic said that some of the boutiques buying her merchandise were located outside the Ottawa area. Many of these boutiques went out of business during the period of recession in the 90s. In her testimony, Ms. Petrovic said that the years at issue were not the time for new investment or for expanding the business. In her words, everybody was trying to survive and she tried to adjust to the market as much as possible. She dedicated all her efforts to staying in business.

Appellant's Argument

[25]          Counsel for the appellant argued that the question raised in the present case is whether Jackie was a business as defined by the Act, thus giving rise to the possibility of deducting business losses. She submitted that the reasonable expectation of profit ("REOP") doctrine has no application in determining the deductibility of business losses. The real question is whether the expenses claimed by the appellant with respect to Jackie's operations were incurred for the purpose of producing or gaining income within the meaning of paragraph 18(1)(a) of the Act.

[26]          Counsel relied on the decision of the Supreme Court of Canada in 65302 British Columbia Ltd. v. The Queen, 99 DTC 5799, and in Shell Canada Limited v. The Queen et al., 99 DTC 5669, for the dictum that the plain meaning of the provisions of the Act must be applied to determine the tax results, and on the same Court's decision for the dictum warning the courts against embellishing unambiguous statutory provisions. She submitted that applying the REOP doctrine in the present case to determine whether the appellant was carrying on a business or not would have the effect of embellishing, or of finding unexpressed legislative intent in, an unambiguous provision of the Act, namely paragraph 18(1)(a). In so doing, the result would be, according to counsel, to apply on a discretionary basis a judicially created anti-avoidance test, something that is not specifically required by the Act. In fact, the Supreme Court of Canada stated in Symes v. Canada, [1993] 4 S.C.R. 695 at p. 736:

. . . no test has been proposed which improves upon or which substantially modifies a test derived directly from the language of s. 18(1)(a). The analytical trail leads back to its source, and I simply ask the following: did the appellant incur child care expenses for the purpose of gaining or producing income from a business?

[27]          Indeed, counsel argued, Parliament has written the REOP test into the Act wherever it has chosen to require its application. For example, the definition of personal or living expenses -- which are prohibited expenses pursuant to paragraph 18(1)(h) of the Act -- in section 248 of the Act refers to the REOP test. Accordingly, that test should apply only to the extent that certain personal assets are used in the course of carrying on Jackie's operations (she referred here to the home and car expenses). But counsel suggested that this does not justify the application of the REOP doctrine to the totality of the expenses claimed with respect to those operations.

[28]          Now, the meaning of "business" was canvassed in Timmins v. The Queen, 99 DTC 5494 (F.C.A.), at 5498:

. . . Although the word "business" when used in the Act must generally envisage an activity capable of giving rise to profits,* it does not require that this activity be undertaken or carried on for the "predominant" purpose of earning a profit.

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* This meaning is dictated by the Act's fundamental raison d'être which is to levy a tax on profits and governs unless a different meaning can be evidenced by specific language or by necessary implication. (See for example the definition of "personal or living expenses," in ss. 248(1) or the language of the loss carry forward limitation is subparagraph 111(5)(a)(i)).

[29]          Counsel suggested that Jackie's operations were a business as defined by the Act and constituted an activity capable of giving rise to profit. According to counsel, the gross revenues from 1987 to 1998, totalling approximately $380,000, show a significant scale of operations which were certainly carried on for profit and not as a hobby or pastime. Counsel suggested that if the appellant wanted only to offset his employment income, there was no need to work so hard on Jackie's operations. She submitted that Ms. Petrovic deserved her salary in the years at issue and that her salary cut in 1997 and 1998 was not unusual as Jackie's operations were undergoing difficult times.

[30]          Counsel appreciated the fact that Jackie's operations were funded by tax refunds but submitted that those moneys were injected into the operation of a business, which is perfectly acceptable under the Act. The fact that the anticipated revenues did not materialize was explained by a downturn in the economy which was unforeseeable and beyond the appellant's control. The appellant curtailed expenditures in 1995, which, in counsel's view, is not indicative of "total indifference to the bottom line of the business" (transcript, Vol. II, at pp. 45-46).

[31]          In the alternative, counsel submitted that, if it should be decided that the REOP test is applicable, the appellant has shown that there existed a reasonable expectation of profit. In fact, a profit was recorded in 1997 before the carry forward of business-use-of-home expenses and a small profit was shown in 1998 after the carry forward of business-use-of-home expenses. Counsel argued that any submission that Jackie's losses were incurred for a personal or non-business motive is unfounded. The REOP test should therefore be applied sparingly and with an attitude favouring the taxpayer, as suggested by the Federal Court of Appeal in Tonn et al. v. The Queen, 96 DTC 6001 (F.C.A.). Counsel argued that the respondent failed to consider the unforeseen difficulties which Jackie's operations experienced due to the dramatic and prolonged slump in the economy during the 1990s. Counsel relied on the decision of the Federal Court of Appeal in Labrèche v. Canada (M.N.R.), [1998] F.C.J. No. 1875 (Q.L.), for the objective factors to be considered in determining whether an expense is deductible or not. Those factors are:

-                the number of consecutive years during which losses were incurred;

-                the time required to make the activity profitable;

-                the time devoted to the business;

-                the profit and loss situation for subsequent years;

-                the reasons behind the increase in expenses and decrease in income;

-                the persistence of the factors causing the losses;

-                the presence or absence of adjustments.

[32]          Counsel also relied on that case for the proposition that a personal element can co-exist with a profit motive. She relied as well on the decision of the Federal Court of Appeal in Kuhlmann et al. v. The Queen, 98 DTC 6652, in which it is stated that a court should:

-                not give the personal element factor greater breadth than is contemplated in the case law;

-                not focus exclusively on the amount of expenses involved;

-                not second-guess the taxpayer's business decisions;

-                take into consideration the unavoidable risks associated with the industry in question;

-                recognize the fact that a minimum number of years is required, even in the best of circumstances, to earn a profit.

[33]          Counsel submitted that there was here a bona fide business whose expectation of profit was not irrational, absurd or ridiculous to use the terms employed in Kuhlmann, supra. Faced with losses and a changing and depressed market, counsel argued, the appellant changed the products of the business in order to earn a profit. But, she submitted, each change meant that the business would take a bit longer to become profitable.

Respondent's Argument

[34]          Counsel for the respondent argued that in the Timmins case, supra, the Federal Court of Appeal recognized the fact that there has to be a reasonable expectation of profit in order to have a business. Although profit does not have to be the overriding motivation, there has to be at least an expectation of making some profit. Furthermore, the Federal Court of Appeal in A.G. of Canada v. Mastri et al., 97 DTC 5420 (F.C.A.), reiterated that even if there is no personal element, the REOP test is still applicable in order to determine whether a business exists, but it has to be applied more sparingly.

[35]          Counsel suggested that there are personal elements in the present case. In his view, Jackie's activity enabled the appellant and his wife to enjoy a better lifestyle at a reduced cost (taking into account the fact that the appellant reduced his tax burden through certain otherwise personal expenditures).

[36]          By means of the activity in question, the appellant was able to split his income with his wife, who was taxable at a lower marginal rate, leaving more after-tax money in the family unit. In counsel's view, during the three years at issue, the significant increase in the management fee paid to Ms. Petrovic made it impossible for the activity to generate a profit.

[37]          According to counsel, the activity did not show a reasonable expectation of profit. We cannot speak of a start-up activity in the years at issue. The appellant acknowledged that the start-up costs were very low ($3,400 according to the business questionnaire filed at Tab 7 of Exhibit R-1). The evidence also revealed that the total amount of capital needed was very limited. No big piece of machinery had to be bought and amortized over the years. No major capital investment needed to be made to develop that type of activity.

[38]          Further, the activity showed consistent losses for the six years preceding the years at issue. Then, in 1993, the appellant increased the management fee paid to his wife regardless of the fact that in the previous years the ability to show a profit never materialized.

[39]          Furthermore, Ms. Shepherd was called as a witness for the appellant to testify from a retailer's perspective. In her testimony she said that in 1998 her own fashion business started to make as much profit as it had in the good years in the 80s. If, as Ms. Shepherd testified, the recession was at its peak in the fashion business in the years at issue and was over in 1998, this is not reflected in the results of Jackie's operations. Indeed, gross revenues from the activity were at their highest in the years at issue, and lower in 1998.

[40]          Counsel also submitted that the gross profit (before deduction of expenses) was lower than the management fees paid to Ms. Petrovic in each of the years at issue. The appellant indeed admitted that by paying a salary to Ms. Petrovic, the activity could not show a profit. Furthermore, the appellant's wife already spent long hours on the activity's regular production. If, as the appellant testified, they needed to sell $100,000 worth of merchandise per year to show a profit given the actual operating costs, that, according to counsel, would obviously mean an increase in Ms. Petrovic's working hours and in her management fees, or in the salaries paid to hired employees. Operating costs would be higher, and the expectation of profit would be foreseeably greatly affected, not to mention unrealistic.

[41]          In counsel's view, the activity was not viable with the payment of management fees. In that context, it is difficult to say that there was a reasonable expectation of profit from this activity in the years 1993, 1994 and 1995.

Appellant's Rebuttal

[42]          Counsel for the appellant replied that the management fees were not paid in one lump-sum payment. It was paid regularly and at that time the appellant was still hopeful that the business would generate a profit. It is only with hindsight that we realize that the management fees were high. Indeed, in 1995 they were reduced. The fact that sales would not increase was not foreseeable in those years. They did not know how long the recession would last. They increased expenditures in the hope that the business would eventually generate a profit.

Analysis

[43]          With respect to the first argument raised by counsel for the appellant, I am of the view that the Federal Court of Appeal has clearly established in its most recent decisions that, in order to have a source of income for the purposes of the Act, the taxpayer must have a profit or a reasonable expectation of profit. (See Tonn, supra, Mastri, supra., The Queen v. Milewski, A-596-99, Sept. 26, 2000 (F.C.A.), and Stewart v. The Queen, [2000] F.C.J. No. 238 (F.C.A.). The REOP doctrine, as it is called by counsel for the appellant, and as adopted by the Supreme Court of Canada in Moldowan v. The Queen, 77 DTC 5213, is still very present in tax law. In Tonn, the Federal Court of Appeal stated at p. 6011:

. . . where a commercial enterprise is operated at a loss in order to generate tax refunds or other such tax consequences, the Court will likely find that the enterprise is not a business under the Moldowan test. In other situations, the Court may decide that, though the taxpayer genuinely intended the pursuit of profit through a purely commercial activity, the intention was unrealistic, the expectation of profit unreasonable, and hence, the activity was not a business.

The fact that an activity must be capable of giving rise to profits in order to constitute a business is, according to the Federal Court of Appeal, dictated by the "raison d'être" of the Act which is to levy tax on profits (Timmins, supra, at 5498). As Rothstein J. said in Stewart, supra, no subsequent Supreme Court of Canada authority has altered the Moldowan principle. Having said this though, I am aware that the application for leave to appeal to the Supreme Court of Canada was granted in the Stewart case, [2000] S.C.C.A. No. 184 and also in Walls v. The Queen, [2000] S.C.C.A. No. 22.[1]

[44]          As I understand it, one of the questions raised before the Supreme Court of Canada in the Stewart and Walls cases is whether the REOP test laid down in Moldowan, supra, for determining the existence of a source of income for the purposes of the Act is in fact only applicable in circumstances where there is a personal element to the activity which is under review. This question stems from a growing body of literature challenging a mostly uncritical acceptance of the REOP test by the courts. According to some authors, this test ought to be of very limited application (see Thomas E. McDonnell, “Rental Losses Denied – Confusion Compounded”, (2000), Vol. 48, No.2, Canadian Tax Journal 444-451, who refers to many articles written on the subject, at p. 450). In this article, Thomas E. McDonnell says:

. . . Where the source of the income is property and the deduction is interest expense, a compelling case can be made that REOP has no application at all. Where the source is a business one, its application may be of some use, but only with respect to the threshold question whether there is a business (pp. 450-451).

[45]          Another author, in discussing the consequences of the Tonn case, states the following:

                Business losses arise when expenses exceed revenue, and there has long existed a body of law on the deductibility of expenses. It is suggested that the question should not be whether a loss should be disallowed; rather, the question should be whether the expenses that made up the loss should be disallowed. This is not mere semantics, for the tax system has a method or hierarchy for testing expense deductibility. . . .

                Thus, the definition of commercial profit and the requirement of paragraph 18(1)(a) call for a subjective or purpose test. If a taxpayer's purpose, however optimistic, is to derive a profit, the expense is deductible. Expenses of a purely personal or non-business nature would not survive this test. The task of the court would not be an objective testing of the taxpayer's wisdom; rather, it would be to test the credibility of his avowed purpose. (pp. 27-1,2,3) (Warren J.A. Mitchell, "Tonn and On and On," in Report of Proceedings of the Forty-Eighth Tax Conference, 1996 Conference Report, vol. 1 (Toronto: Canadian Tax Foundation, 1997), 27:1-5 at pp. 27-1,2,3).

[46]          In Kaye v. The Queen, 98 DTC 1659, Judge Bowman stated the following, with respect to the application of the REOP test, at p. 1660:

                I do not find the ritual repetition of the phrase particularly helpful in cases of this type, and I prefer to put the matter on the basis "Is there or is there not truly a business?" This is a broader but, I believe, a more meaningful question and one that, for me at least, leads to a more fruitful line of enquiry. No doubt it subsumes the question of the objective reasonableness of the taxpayer's expectation of profit, but there is more to it than that. . . . It is the inherent commerciality of the enterprise, revealed in its organization, that makes it a business. Subjective intention to make money, while a factor, is not determinative, although its absence may militate against the assertion that an activity is a business.

[47]          In the present case, I find, contrary to the appellant’s submissions, that a personal element certainly exists in the circumstances of the case and that, at first glance, the enterprise did not reveal in its organization any inherent commerciality. In Tonn, supra, Linden J.A. said at p. 6009:

Whatever the particular circumstances, transactions contrary to the purposes of the Act are generally those where the underlying aim is inappropriate tax avoidance. The attempt to deduct the costs of what are essentially hobby or personal expenses as a business expense is one good example. As common sense might suggest, the Act’s fundamental purposes are not easily construed as contemplating such tax avoidance. It is, I believe, in this spirit that Dickson, J. penned the Moldowan test.

I have dwelt upon the issue of the origin of the “reasonable expectation of profit” test because a proper understanding of it is necessary to the resolution of this application. As a common law formulation respecting the purposes of the Act, the Moldowan test is ideally suited to situations where a taxpayer is attempting to avoid tax liability by an inappropriate structuring of his or her affairs. One such situation is the attempted deduction of an expense incurred to gain a tax refund.²⁶ Another is an attempt by a taxpayer to deduct personal housing expenses under the guise of a free-lance typing business operated by his wife.²⁷ These cases are merely instances where an inappropriate use of the Act is attempted, and where the Moldowan test has rightly denied deductibility on the basis that the Act’s purposes would otherwise be violated.

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²⁶              See Moloney [v. The Queen, 92 DTC 6570].

²⁷              Geurts v. Q., 95 DTC 89, per Couture C.J.T.C.C.

[48]          One has only to look at the statement of business activities filed with the appellant’s tax returns to see that apart from the management fees, the major expenses claimed are vehicle and home expenses. Those are expenses that would have been incurred irrespectively of the existence of a business, and therefore personal in nature. Indeed, in elucidating factors to be considered in determining whether a deduction is to be allowed as a business expense, the Supreme Court of Canada stated the following in Symes, supra, at p. 737:

                It may also be relevant to consider whether a particular expense would have been incurred if the taxpayer was not engaged in the pursuit of business income. Professor Brooks comments upon this consideration in the following terms (at p. 258):

If a person would have incurred a particular expense even if he or she had not been working, there is a strong inference that the expense has a personal purpose.

[49]          Furthermore, the fact that, during the years at issue, the appellant paid more than one quarter of his personal salary to his wife and that this salary to his wife was higher than the gross profit generated by the activity tends to show, in my view, that there was an attempt to avoid tax liability by an inappropriate structuring of the appellant's affairs, as contemplated in the Tonn case. Consequently, the Moldowan test is, as Linden J.A. said, ideally suited to that kind of situation.

[50]          I am therefore of the opinion that the case law is such that the REOP doctrine is applicable to determine whether, in the present case, the appellant had a source of income with respect to the activity in question. Furthermore, if I stated accurately one of the questions raised before the Supreme Court of Canada in Stewart and Walls, supra, those decisions should have no impact on the present case, as I have found that personal elements are involved here.

[51]          I will now turn to the alternative argument raised by the appellant. It was said in Tonn, supra, that the Moldowan test should be applied sparingly where a taxpayer’s business judgment is involved, where no personal element is in evidence and where the deductions claimed are not on their face questionable. At page 6013, Linden J.A. adds the following:

However, where circumstances suggest that a personal or other-than-business motivation existed, or where the expectation of profit was so unreasonable as to raise a suspicion, the taxpayer will be called upon to justify objectively that the operation was in fact a business. Suspicious circumstances, therefore, will more often lead to closer scrutiny than those that are in no way suspect.

[52]          Counsel for the appellant stated some factors to be considered in determining whether there was a reasonable expectation of profit. Other factors to be assessed are listed in Sipley v. The Queen, [1995] 2 CTC 2073 (T.C.C.) and reproduced in Tonn, at p. 6013:

The objective test includes an examination of profit and loss experience over past years, also an examination of the operational plan and the background to the implementation of the operational plan including a planned course of action. The test further includes an examination of the time spent in the activity as well as the background of the taxpayer and the education and experience of the taxpayer.

[53]          In Kaye, supra, Judge Bowman analyzed the question under a slightly different angle at p. 1660:

                One cannot view the reasonableness of the expectation of profit in isolation. One must ask "Would a reasonable person, looking at the particular activity and applying ordinary standards of commercial common sense, say 'yes, this is a business'?" In answering this question the hypothetical reasonable person would look at such things as capitalization, knowledge of the participant and time spent. He or she would also consider whether the person claiming to be in business has gone about it in an orderly, businesslike way and in the way that a business person would normally be expected to do.

[54]          In the present case, I agree with counsel for the respondent that the appellant has not shown that he could reasonably expect to make a profit from his activity. The activity had been carried on for almost ten years when the appellant was audited for the second time. The activity constantly showed losses. According to the appellant himself, there was no possibility of making a profit if management fees were paid. Indeed, in each taxation year at issue the gross profit before deducting any expenses was lower than the management fees paid to his wife.

[55]          The appellant estimated that he would need to sell $100,000 worth of merchandise before he could ever think of making a profit. However, in 1994, the activity's best year for sales, it did not even attain $50,000. It was established that in the years at issue, the time spent on the activity could vary between 60 and 90 hours per week. It is difficult to imagine that Ms. Petrovic, who was the one who was really involved in this venture, could have devoted any more time to it. To attain the target of $100,000 in sales, it is obvious that the appellant would have had to hire other personnel and costs would have risen accordingly.

[56]          It is true that the courts allow a grace period for emerging operations (this has been confirmed by the Federal Court of Appeal in Tonn, supra, and in Labrèche, supra). Indeed, as Linden J.A. said in Tonn, several years may pass before one can tell whether a business will be profitable. In fact, this is the reason why, I suppose, the Minister accepted the appellant’s losses from his activity in the first years. However, in the years at issue, the activity had been carried on for six years without showing any profit. In 1990, a very good year compared to others, revenues reached $40,000 and the management fees were not very high, yet the activity did not show a profit.

[57]          In the years at issue, the cost of goods sold was lower (the appellant having decided to keep a smaller inventory) but the losses were even greater despite revenues being at their peak, as the appellant had decided to raise his wife’s remuneration significantly (the management fees). It is obvious that the kind of activity involved here did not necessitate a heavy capital outlay. This is not a case where the appellant was not given enough time to prove the viability of the operation.

[58]          The appellant attributes his losses during the years at issue to the recession. However, according to his own witness, Ms. Shepherd, the fashion design industry had its bad years in the mid 1990s and started becoming profitable again in 1998. In the appellant’s case, his gross income from the activity was highest in 1993 and 1994. In 1998 and 1999, the activity did not show a loss because insignificant management fees or none at all were paid in those years.

[59]          It is therefore difficult to attribute the appellant’s losses wholly to the recession. Although it is not the place of this Court to second-guess the business acumen of a taxpayer who embarks bona fide on a commercial venture that turns out to be less profitable than anticipated, there must be sufficient indicia of commerciality to justify the conclusion that there is a real commercial enterprise being conducted (see Riddell v. The Queen, [1996] T.C.J. No. 1100 (T.C.C.)). It is true that Ms. Petrovic had experience in the field and that her salary would not, in other circumstances, have been unreasonable. However, as Chief Judge Couture, as he then was, stated in Geurts, supra, in relation to the nominal gross income of the venture, that salary was out of line. In that case, the taxpayer’s spouse operated a free-lance typing service of which the taxpayer himself was the sole proprietor. Chief Judge Couture denied in the following terms the losses claimed, at p. 91:

As I said before, a formal market survey may not be necessary but there must at least be some evidence of potential economic profitability for the venture. To rely only on good intentions and hope is not sufficient to establish to the satisfaction of the Court that the venture had from the outset a reasonable expectation of profit.

For instance, the Appellant failed to demonstrate to the Court that included in the fees for the services performed by his wife was an element of profit. For instance in 1987 she was working at the rate of $15 per hour according to his testimony but there is no evidence that whatever the client was charged for her services whether on an hourly basis or under another arrangement a profit was realized by the enterprise. In my opinion, it is essential that the Appellant demonstrate to the Court that there was an element of profit in the revenues earned by the venture and that an increase in their volume could eventually give rise to a net profit.

In the light of the evidence that was adduced, I have nothing to rely on which would indicate that the venture has a reasonable expectation of profit, and for these reasons the appeals must be dismissed.

[60]          Here, I do not find that the appellant has shown potential economic profitability for the venture. I find that, as in the Geurts case, the appellant failed to demonstrate that an element of profit was included in the fees for the services performed by his wife, that is, that the clients were charged for those services or that a profit was realized by the enterprise under another arrangement. On the contrary, the appellant has recognized that there was no possibility of profit if such management fees were paid. Applying ordinary standards of commercial common sense, this is certainly not the way a reasonable person would go about running a business. In my view, it is no more an appropriate structuring of a taxpayer's affairs not to pay a salary to his key employee just in order to show a profit. (Indeed, I find striking the fact that the appellant cut the management fees to his wife in the years following the second audit.) In fact, I do not think a business person would have hired an employee for so long a time if it meant incurring a recurrent loss year after year. Nor do I believe that a business person would have expected in any circumstances to be able to keep a key employee without a salary.

[61]          Finally, I do not find that the appellant had a planned course of action with respect to this activity. The evidence reveals that he was trying to adjust on a year-by-year basis, but without investing too much money. In fact, he did not have much to lose as the activity was run from his personal residence. I do not think that this conduct can be compared to the implementation of an operational plan. On the contrary, it was all for the benefit of the appellant, who was able to derive tax refunds from personal expenditures.

[62]          In conclusion, although I would not go so far as to characterize the expectation of profit from the venture as being absurd and ridiculous (which seems to be a new factor put forward in Kuhlmann, supra), and though the appellant might genuinely have intended the pursuit of profit through this activity, he has not convinced me that this intention was realistic and that the expectation of profit was objectively reasonable. I doubt that from a purely commercial perspective the appellant would have kept that kind of activity running at a loss for ten years, or that, applying ordinary standards of commercial common sense, a business person could be expected to sustain such losses for so long in similar circumstances.

[63]          The following passage from the case of Landry v. The Queen, 94 DTC 6624 (F.CA.), at p. 6625 is apposite here:

It is possible for someone, with the best will in the world, to practise an activity that takes all his or her time and that activity may still not be a business for the purposes of the Income Tax Act. . . .

There comes a time in the life of any business operating at a deficit when the Minister must be able to determine objectively, after giving someone a head start for a number of years, as the case may be, that a reasonable expectation of profit has turned into an impossible dream.

[64]          In the circumstances, I do not find that the appellant has shown on a balance of probabilities that he was operating a business during the years at issue. The net losses claimed by the appellant in those years were therefore rightly disallowed by the Minister in the assessments under appeal.

[65]          For these reasons, the appeals are dismissed with costs.

Signed at Ottawa, Canada, this 30th day of January 2001.

"Lucie Lamarre"

J.T.C.C.

SCHEDULE "A"

Jackie's Fashion Design

Amounts Reported and Claimed by the Appellant in Filing his T1 Income Tax Returns for 1987 through 1998

Taxation Year	Revenues	Expenses	Cost of Goods Sold	Management Fee	Net Income/ (Net Loss)	Employment Income
1987	$17,367.00	? &	? &	$ 6,000.00	$(12,424.00)	$45,000.00
1988	23,538.03	$12,674.45	$24,152.74	10,500.00	(13,289.16)	53,966.34
1989	30,403.30	9,187.17	29,725.68	7,170.00*	(8,509.55)	56,276.14
1990	40,485.32	23,104.05	32,450.39	7,707.00*	(15,069.12)	? &
1991	21,651.13	22,234.11	17,053.78	7,105.00	(24,662.00)	? &
1992	29,774.35	38,436.91	13,518.64	? &	(22,181.20)	66,612.82
1993	43,347.58	62,803.35	19,159.72	26,690.00	(38,615.49)	69,414.36
1994	45,817.04	70,689.04	18,826.02	29,300.00	(43,698.02)	79,203.38
1995	31,949.94	56,883.81	14,099.52	21,552.65	(39,033.39)	81,985.19
1996	20,451.99	36,816.84	7,321.44	8,550.00	(23,686.29)	98,298.07
1997	41,771.73	15,466.22	20,348.97	1,000.00	0.00+	82,914.00
1998	34,068.17	13,347.58	16,320.21	0.00	303.16+	85,745.00

* Not deducted as an Activity expense.

⁺ After carryforward and application of business-use-of-home expenses. Before that carryforward and application, net income for 1997 was $5,956.54, and for 1998 was $4,400.38.

^& Information not available.

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