Date: 20010102
Docket: 97-1632-IT-G; 97-1633-IT-G
BETWEEN:
RONALD JAMES MILLER, R.J. MILLER & ASSOCIATES (1986)
LTD.,
Appellants,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
McArthur J.T.C.C.
[1]
These appeals were heard together on common evidence. Ronald
James Miller ("Miller") appeals his 1992, 1993 and 1994
taxation years and R.J. Miller & Associates (1986) Ltd. (the
"Corporation") appeals the taxation years ending
February 28, 1993 and 1994. The Corporation also appealed its
taxation year ending February 29, 1992 but, since no issue was
brought forward with respect to 1992, I will deal only with its
1993 and 1994 taxation years. The single issue to be determined
for Miller is whether he received a taxable benefit pursuant to
subsections 6(1) or 15(1) of the Income Tax Act (the
"Act"). The issues concerning the Corporation
include:
(a)
is $100,000 the fair market value of a 50% interest in the
software which was purchased by the Corporation from Miller?
(b)
did the Corporation's Firearms Division have a reasonable
expectation of profit and if so, was it therefore a business?
and
(c)
did the Corporation incur scientific research and experimental
development (SRED) expenditures?
[2]
The Minister of National Revenue (the "Minister")
reduced the capital cost allowance claimed by the Corporation in
1993 and 1994 in respect of computer software stating that at the
time of acquisition, the software's value was no more than
$100. The Minister disallowed the Corporation's claim for net
expenditures in its 1993 and 1994 taxation years in the amounts
of $39,347 and $51,034, respectively, in connection with its
Firearms Division. And lastly, the Minister disallowed the
Corporation's claim for investment tax credits arising from
its SRED expenditure claims in respect of the Shotgun Development
Project in its 1993 and 1994 taxation years. The investment tax
credits claimed in 1993 and 1994 were based on SRED expenditures
of $26,943.47 and $36,115.97, respectively. In reassessing Miller
for his 1992, 1993 and 1994 taxation years, the Minister added
$39,350, $44,515 and $6,519, respectively, to his income as
shareholder benefits or, in the alternative, as employee
benefits, conferred upon him by the Corporation.
[3]
Miller is the sole director and shareholder of the Corporation.
He is a determined, self-confident business consultant. He is an
accountant who was employed by the Corporation to give clients
business and tax advice. He has no track record in the field of
innovated inventions in the software field and in fact, he did
not own a computer until 1990. The Corporation's major client
was his wife's law firm which it billed $100,000
annually.
[4]
Throughout his life, Miller has shown an extraordinary interest
in the sport of skeet and trap shooting which led to his
directing the Corporation to enter the firearms business.
Software Facts
[5] I
will first deal with the software issue. To advance the
efficiency of his wife's law practice and his own
corporation, Miller co-developed custom-made software motivated
by a need to track billable hours. He conceived software for
which he had computer programmer James Webber
("Webber"), develop. He had tried several ready-made
programs that did not suit his needs in the management of the law
firm. Prior to his introduction of the computer software to his
wife's law firm, she had three associate lawyers. The
associates left just prior to the introduction of the program
mainly because they were not prepared to track their time and
billings through the new computer system. A recap of the software
project prepared by Miller reads as follows:[1]
1.
Original version written in Pascal substantially completed by
September, 1992.
2.
Disposition of Rights to R.J. Miller & Associates (1986) Ltd.
by Appellant Ron Miller on December 12, 1992.
3.
Acquired Database Programming Software from Borland January 21,
1993.
4.
Development Vehicle Incorporated May 17, 1993.
5.
Database Version 1.0 for Law Offices substantially completed by
December 4, 1993.
6.
Acquired Database Programming Software Upgrade from Borland
January 21, 1994.
7.
Database Version 2.0 for Law Offices substantially completed by
March 1994.
8.
Database Version 2.0 for Accounting Offices substantially
completed by June 1994.
9.
US & Canadian Copy Rights & Trademark Rg. Version 2.0
completed by December 28, 1994.
10.
User Manuals (all Version 2.0 Applications) completed by March
1996.
[6]
In 1990, Miller reviewed various marketed software programs
before commencing his own project. He was not a computer
programmer and had never created a software program. The
Corporation paid Webber to write a customized computer program
developed on a product named Pascal and the software was named
"RJs Law". It was designed to track billable hours,
work-in-progress, disbursements and assist in file management.
The Corporation purchased the necessary hardware and the software
was tested over a two-year period. It was primarily used in
Miller's wife's legal practice. By December 1992, the
Pascal base program had developed problems, in particular, the
problem of crashing, which rendered its intended use
unfeasible.
[7]
At the same time, on December 12, 1992, Miller sold his 50%
interest[2] in the
rights to the software program to the Corporation for $100,000.
The Corporation was not at this time in the business of producing
and marketing software. The Corporation capitalized its
acquisition and claimed depreciation as provided for in the
Act for Class 12 assets.
[8]
After the December 1992 sale, Miller and Webber converted the
software to a database format on behalf of the Corporation.
Webber rewrote the program using Borland Paradox programming. It
was completed and available to be marketed in late 1994, two
years after the Corporation had acquired its 50% interest in the
Pascal version. By 1995, the $100,000 capital cost had been
completely depreciated by the Corporation. Simplexity Software
Solutions Inc. ("Simplexity") was incorporated as a
vehicle to own the enhanced database version of the RJs Law
software.
[9]
On February17, 1994, the Corporation and Webber assigned their
rights in the enhanced database version of RJs Law Database to
Simplexity at a nominal value of $100 in consideration for common
shares of Simplexity. The $100 value was the undepreciated
balance of the original software carried on the books of the
Corporation at the date of the rollover in 1994. In 1994,
copyright to the name RJs Law was registered in the US and Canada
to Simplexity. Trademark registration in RJs Law was later
registered in Canada and the US. In December 1994, the
Corporation and Webber assigned their rights to a second version
of the enhanced database version of RJs Law software to
Simplexity as well. Apparently, to date the RJs Law software, as
marketed by Simplexity, has been sold to five or six law firms in
Kelowna and area.[3] Miller and Webber were the only witnesses with respect
to the software issue. Miller's wife was not called on to
give evidence and no independent evidence of value was
offered.
Appellant's position
[10] The
$100,000 was a reasonable valuation of Miller's 50% interest
in the RJs Law software in December 1992. At that time, the
software was to be used by the Corporation primarily for the
management of his wife's law office. In arriving at the
value, Miller stated he invested 443.7 hours into developing the
software and at $100 per hour, this amounted to $44,370. He
further incurred costs of $22,447 for equipment. The Appellants
submitted, through Miller's testimony only, that the
Corporation and his wife's law firm enjoyed financial
benefits from their use of the software. Miller also submitted
that Webber used the $100,000 acquisition cost in his income tax
returns as well, the reassessment of which is statute-barred.[4]
Respondent's position
[11] The
Respondent's position is that:
(a)
The software was not in marketable condition when
transferred.
(b)
Its fair market value was not more than $100.[5]
(c)
No independent evidence of value was submitted.
(d)
The evidence was not consistent to the effect that the software
benefited the Corporation.
(e)
In the alternative, the Respondent submitted that paragraph
13(7)(e) of the Act would apply to reduce the
Corporation's capital cost allowance.
(f)
Miller had been paid, through his management fees, for a
substantial portion of the hours he claimed to be part of the
costs.
(g)
Much of the recorded time by Miller related to the management
services that he provided his wife's law firm and, therefore,
his capital cost on sale was zero.
Software Conclusion
[12] I have no
difficulty concluding that the Corporation did not satisfy its
onus to demolish the assumptions of the Minister. The evidence of
the accountant was of little assistance as to value. The
self-serving testimony of Miller as to the value is not
sufficient. The Appellants had the onus of proving that the fair
market value and cost of the software in December 1992 was
$100,000 and not $100. It appears that Miller prevented the
Minister from examining the software on the Minister's terms.
The Corporation was using the software without a $100,000
expenditure many months before the transfer to it of Miller's
50% interest.
[13] Webber
testified he accepted the one-half interest value at $100,000. He
was not an independent witness nor could he be considered an
expert witness for the purposes of evaluating his own software.
He testified that he worked on establishing the software and was
paid by the Corporation for his time.
[14] There was
no expert evidence to establish the value and Miller's
explanation was unconvincing. He relied on the time he spent and
other expenses which totalled $66,817. He relied further on
general statements to the effect that the software benefited his
Corporation financially. The evidence in this regard pertained to
the benefit enjoyed by his wife and her law practice. I draw an
adverse inference from the fact that Miller's wife did not
testify nor did anyone who might qualify as an expert computer
software appraiser. Miller's claim that he spent $66,817 was
not corroborated in any way nor does it establish the value of
the software. Also, I am satisfied that for the most part, the
costs incurred by Miller were paid to him by the Corporation
prior to the transfer. The evidence was insufficient and
unclear.
[15] Miller
was overly aggressive in his tax planning. There is nothing wrong
in minimizing tax and a taxpayer may obtain substantial benefits
from so doing, but Miller, on behalf of the Corporation, went
well beyond the scope permitted by the Act when he
transferred his software to the Corporation at an inflated value.
Even if I accept that the value of the software was $100,000, I
agree with the Respondent that paragraph 13(7)(e) of the
Act would apply to reduce the Corporation's capital
cost on the software and, therefore, the available capital cost
allowance. This reduction would have been such that the
Corporation would not have received the huge capital cost
allowance benefit that Miller had tried to orchestrate.
[16] In
conclusion, the Minister correctly and properly reassessed the
Corporation to reduce the allowable capital cost allowance
claimed by the Corporation in respect of the RJs Law computer
software program on the basis that the cost of the program to the
Corporation was equal to its fair market value which was not more
than $100.
Firearms Facts
[17] Miller
and his son were immersed in skeet and trap shooting activities
including competitions. It was obviously a passion for them. By
Resolution dated March 1, 1992, the Corporation purported to set
up a Firearms Division directed towards developing a world-class
competition shotgun.
[18] In the
Corporation's 1993 and 1994 taxation years, the net expenses
in respect of its Firearms Division were reported as follows:[6]
|
|
28 Feb 1993
|
28 Feb 1994
|
28 Feb 1995
|
|
Net Losses:
|
($39,349.57)
|
($51,034.48)
|
($16,988.97)
|
The Corporation came within $8,000 of breaking even in the
year ending February 28, 1996. The stand-alone products,
designed to be incorporated in the new shotgun were starting to
bring in modest income on their own.[7] There were other sources of income
within the Firearms Division such as Calcutta[8] and revenue from the prize
monies.
[19] Miller
and his son attended and participated in the Grand American
Trials in Vandalia, Ohio in August 1992.[9] His then 16-year old son won 13 of 16
events and earned the reputation as a world class shooter. Miller
who also competed, spent time educating himself with regard to
the construction of shotguns. He acquired Ljutic guns to be used
as prototypes. An accomplished gunsmith, Chris Weber[10] of Kelowna was
retained by the Corporation to construct stand-alone components
to be incorporated in the final prototype. As of the date of the
hearing, no custom shotgun had been completed. The Corporation
records indicate no payment to Weber until December 1994, which
of course is in the Corporation's 1995 taxation year.
[20] The
"Miller Kwik Change Stocks", a stand-alone innovation,
was conceptualized in August 1992 in Ohio because of the
difficulties competitors were incurring due to the climate.
Because of the wet weather, some of the gun parts rusted and did
not function effectively. The design was completed and the
prototype conversion of existing stocks on the test pieces
commenced by the end of February 1993. The unfitted prototypes
were completed and installed in early June 1993 with completion
being October 1994. Final modifications occurred in November
1994. Initial product sale occurred in February 1996.
[21] Another
innovation developed by the Corporation was the "Convertible
Trigger" which is a shotgun trigger that offers both
'pull' and 'release' firing options. It came
about through Miller's personal problem with flinching. The
flinch reaction by a shooter adversely affects shooting scores.
Flinching is the body's automatic reaction immediately before
pulling the trigger. Ones body anticipates the violent kick back
after the shell explodes. Discussion for the work began in
June 1993 and an initial prototype was commissioned in
August 1993. The work was substantially completed by October
1993. From the flinching came the idea of changing the recoil
system.
[22] There
were recoil mechanisms on the market that Miller was going to use
for his custom shotgun, however, it was not until he incurred his
personal problems with flinching that he decided to improve the
design. The "KIKOFF Recoil System", another stand-alone
innovation, was finalized after the Corporation's 1994 year
end. The test background studies included looking at score data
before and after the receiver-trigger work was done. Development
of the prototype began in December 1995 and sales of some
component parts were made in February 1996. Eventually, trademark
registration for "KIKOFF" and design was received in
1997.[11]
[23] By Order
dated June 26, 2000, I granted the Appellants' motion to the
effect that additional evidence of the Corporation be admitted.
This was evidence was set out in an affidavit of Miller with
exhibits attached thereto and the evidence included that since
the hearing of these appeals (October 1999): (i) a prototype
shotgun has been completed (colour photographs attached to the
affidavit); (ii) prototypes of three gun cases were developed;
(iii) an advertising and marketing campaign was commenced
for the shotgun and the cases; and (iv) an application for a
firearms manufacturer's license and a trademark have been
made. Pursuant to the June 26 Order, the parties made submissions
with respect to whether these additional facts assist in deciding
if the Corporation commenced the shotgun business at an earlier
date. I have found the additional facts relevant and have taken
them into consideration in arriving at a decision.
[24] In
November 1996, the Business Development Bank loaned the Firearms
Division of the Corporation $30,000 to finance the custom shotgun
project in part. Up until that time, the Corporation had been
financing the development process alone.
Appellant's Position
[25] The
Appellants submitted that the business commenced in March 1992
and that it had a reasonable expectation of profit from the
development and sales of custom-made shotguns. Numerous steps had
been taken and funds expended. Prior to the corporate Resolution,
Miller had accumulated research and experience at his own
expense. He established the need within the marketplace for a
"breakdown proof" competition shotgun that would sell
in excess of US$20,000. Given the nature of the gun manufacturing
industry, counsel for the Appellants argued that it was
reasonable that there would be a start-up period during which it
would sustain losses prior to substantial sale revenues. There
was a two-year delay in completing a prototype. The question is
whether the expenses claimed were incurred for the purpose of
gaining or producing income from a business or property pursuant
to paragraph 18(1)(a) of the Act.
Respondent's Position
[26] At the
end of the Corporation's 1993 taxation year, it was simply in
the concept stage and not the operational stage. Among the
preliminary steps was the product evaluation done by Miller in
1992 on his own guns. In addition, the event in August 1992 in
Ohio was simply a fact-finding mission before which he had no
clear idea of exactly how he was going to set up his
manufacturing business. Therefore, all the expenses incurred in
the Corporation's 1993 taxation year were not business
expenses as there was no business. Furthermore, the guns
purchased and traded were capital expenditures.
[27] The
business may have commenced in the Corporation's 1994
taxation year with the work done with respect to the quick change
stocks (i.e. the "Miller Kwik Change Stocks") as
arguably it was an essential preliminary step in the development
of the prototype shotgun. However, the Respondent submitted that
the convertible trigger mechanism (i.e. the "Convertible
Trigger") was actually a personal expenditure to deal with
Miller's flinch problem.
Analysis
[28] I
permitted Miller, on behalf of the Corporation, to voice his
complaints of the Minister's approach and lack of expertise
which of course is not relevant and has not been taken into
consideration. What is relevant is what was presented in evidence
during the trial. The issue narrows down to whether the
Corporation was in the business of manufacturing custom shotguns
or shotgun parts in its 1993 and 1994 taxation years. To have a
business, a taxpayer must have a reasonable expectation of
profit. A reasonable expectation of profit is an objective test
and involves more than just a hope or a dream. As stated by
Hamlyn J. in Watt Estate v. The Queen[12]at page 425:
The purpose of an expectation of profit determines whether income
from a particular source is income from a business. The
expectation of profit is central to the concept of a business and
distinguishes it from the pursuit of a hobby. The determination
of a reasonable expectation of profit is a finding of fact.
Thus, if as a matter of fact a taxpayer is found not to have a
reasonable expectation of profit, then there is no business and
the taxpayer cannot claim any expenses in connection with that
activity.
[29] When
reviewing whether there is an expectation of profit and there is
determined to be a personal element involved, Linden J.A. of the
Federal Court of Appeal stated in Tonn v. The
Queen[13] at
page 6013 that:
... 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.
[30] The
involvement of a personal element is not the determining factor
as to whether there is a business. Linden J.A. in Tonn,
supra, after examining the jurisprudence, stated at page
6010:
It is not that the impugned activities in these cases are in
themselves any more or less prone to being run like a business.
Rather, it is the simple fact of how they are run which is
decisive: though the taxpayer might well desire to profit from
the activity, the profit motivation is not the main reason for
the activity. Rather, the element of personal enjoyment is the
dominant, motivating force.
[31] In these
appeals, there is without question, a strong personal element.
Guns, shooting and competitions are obviously an expensive
passion for Miller. He is an accountant and business tax
consultant. There is, no doubt, an inference or strong suspicion
that he created a plan to have the Corporation and Revenue Canada
support his and his son's hobby. These suspicious
circumstances must be closely scrutinized. The Corporation's
Resolution was passed shortly before the costly trip of Miller
and his son to the US World Championship in Vandalia, Ohio. Other
than information gathering and the acquisition of a Ljudic gun,
no development work was commenced at the Championship. The
expenditures claimed from March 1, 1992 to February 28, 1993 do
not appear to be any different from the type of expenditures that
Miller and his son, as very active shooters, would have incurred,
business or no business. While one should not be penalized
because he enjoys a business activity,[14] the facts must be carefully
examined. It is obvious that Miller would want to perfect his
shotguns to improve his personal performance and that of his
son.
[32] Where a
personal element is involved, the question may arise as to when
an activity changes from being a hobby, with no expectation of
profit, to a business, with an expectation of profit. The
determination is a question of fact. The comment of Bowman J. in
Gartry v. The Queen[15] is helpful in determining whether a
business has commenced. He stated at page 1949:
... In determining when a business has commenced, it is
not realistic to fix the time either at the moment when money
starts being earned from the trading or manufacturing operation
or the provision of services or, at the other extreme, when the
intention to start the business is first formed. Each case turns
on its own facts, but where a taxpayer has taken significant and
essential steps that are necessary to the carrying on of the
business it is fair to conclude that the business has started.
...
[33] After
commenting that "[i]nterpretation bulletins are of course
not the law and they should be referred to with some
caution", Bowman J. in Gartry, supra, went on to say
at page 1949 that the observations in Interpretation
Bulletin IT-364,[16] "make eminently good sense both as a
matter of law and as a matter of business reality".
Paragraph 2 of that Bulletin states that:
... In order that there be a finding that a business has
commenced, it is necessary that there be a fairly specific
concept of the type of activity to be carried on and a sufficient
organizational structure assembled to undertake at least the
essential preliminaries. ... Where an activity consists
merely of a review of various business possibilities in the
expectation or hope that information will be obtained to justify
going into a business of some kind, such an activity does not
represent the commencement of a business. A business would be
reviewed as being merely contemplated for the future if no
serious or reasonably continuous efforts are being made to begin
normal business operations. ...
[34] On March
1, 1992, Miller as director of the Corporation resolved to set up
a separate operating division to be known as the Firearms
Division. He also resolved to proceed immediately with such
research and development to facilitate the venture. A Resolution
on its own is in no way sufficient proof that a taxpayer has
taken "significant and essential steps that are necessary to
the carrying on of the business." The taxpayer must prove
that there was sufficient activity that went beyond the mere
gathering of information.
[35] During
the Corporation's 1993 taxation year, Miller was gathering
information about the possibility that there was a market and a
need for an improved custom competition shotgun. As Miller's
counsel submitted, it was at the Vandalia Championship that
Miller confirmed that there was a market and that there was a
need for an improved shotgun. In addition, Miller stated on
page 392 of his original submissions that one of the
business reasons to create the Firearms Division of the
Corporation was "that my son had achieved sufficient status
as a world class competitor, setting a new world record at
Vandalia, Ohio's Grand American, and winning 13 out of
16 events in the process, in August of 1992". It was after
the competition that Miller had gathered enough information to
justify the Corporation commencing to design and market
improvements to a shotgun. Prior to the conclusion of the
Vandalia Championship, Miller was only reviewing possibilities
with a hope of finding a financially viable venture.
[36] During
the Corporation's 1994 taxation year, actual work commenced
on modifications that were intended to be incorporated in the
prototype. These modifications included the Convertible Trigger
and the Miller Kwik Change Stocks. The prototype for the
Convertible Trigger was substantially completed by October 1993.
The Miller Kwik Change Stock was installed in June 1993 and was
last modified in November 1994.
[37] Miller
may have had a desire or idea to have the Corporation construct
custom shotguns prior to the Vandalia, Ohio competition, but
aspiration alone is not enough. I find that the Corporation
commenced a firearms business after the Vandalia, Ohio
competition in August 1992 and, therefore, all expenses that were
incurred prior to and during Vandalia are not deductible.
[38] Having
found that a business commenced after the Vandalia competition,
what expenses, if any, are allowable from those claimed? During
the hearing, the Respondent amended the Reply to the Notice of
Appeal to include section 67 of the Act which limits
deduction of expenses to those that are "reasonable in the
circumstances". The Corporation's gun business did
little else but the aforementioned modifications that were made
by Weber. I find that the travel and competition costs of the
claimed expenses were personal and not for the purpose of earning
income from a business and in any event were unreasonable in the
circumstances. The evidence with respect to the need for testing
was somewhat ambiguous. Again, there was no expert evidence to
support the need for the testing expenses. The evidence of Miller
alone is insufficient and unsatisfactory and Weber was not
qualified in Court nor introduced as an expert witness. I find
that the Corporation has not satisfied its burden of proving the
need to travel and shoot at various competitions to advance its
business.
[39] The
Respondent's counsel submitted that only a portion of the
ammunition costs should be deductible since a portion of the
costs were incurred for personal purposes. The Respondent
submitted that the appropriate percentage is the amount allowed
in respect of testing the gun for research purposes and that
amount should be 50% of the amounts expended. I agree with this
position since no further evidence was presented to assist the
Court in determining what portion of the ammunition costs and
practice targets should be disallowed, I find, applying section
67 of the Act, that 50% of the costs claimed for
ammunition and practice targets are deductible.
[40] The
Respondent submitted that the equipment repairs and maintenance
expenditures in 1994 could possibly qualify as a business expense
but not as a SRED expenditure. Counsel for the Corporation did
not address the equipment repairs and maintenance expenditures in
his submissions. There was no clear evidence as to what equipment
was repaired and maintained. Since it is probable that the
repairs and maintenance expenses were with respect to the guns, I
find that 50% of the repairs and maintenance expenses is
deductible as reasonable in the circumstances.
[41] I also
find that the cost of the guns to be used in the research and
development were not capital expenditures since the guns were
used in whole or in part as the base for the stand-alone
additions. As such, the cost of each of the guns is deductible as
a business expense.
[42] The
Respondent submitted that costs incurred to purchase the skeet
traps were personal expenditures. The Respondent submitted that
the skeet traps were donated to the North Okanagan Gun Club by
the Corporation because the Club did not own skeet traps and
Miller's son was interested in taking up skeet shooting.
Counsel for the Corporation did not address this issue in his
submissions. I find that the Corporation did not meet its onus to
prove that the amount was not a personal expenditure. I find that
the costs incurred to purchase the skeet traps were personal
expenditures.
Firearms Conclusion
[43] All the
expenses incurred prior to and during Vandalia were personal
expenses and therefore not deductible.
[44] With
respect to expenses incurred after Vandalia, I find that the
airfare, vehicle operating, hotels and meals, entry fees, and
skeet trap (including duty) expenses are not deductible since
they were personal and not incurred for the purpose of earning
business income. I also find that 50% of the ammunition costs,
practice target costs and repairs and maintenance were personal
and not incurred for the purpose of earning business income. The
ammunition costs, practice target costs and repairs and
maintenance were unreasonable in the circumstances and that 50%
of the claimed amounts are reasonable and deductible. All other
expenses claimed are allowed.
SRED Facts
[45] It is
clear that an Appellant has the burden of proof to show that the
Minister's assumptions are incorrect. Usually in situations
dealing with a specialized and technical area, the Court looks to
be instructed by experts. In this case the use of experts was
badly lacking on both sides. The Corporation's evidence was
presented primarily by Miller who certainly is knowledgeable but
far from independent. The evidence of Weber, while an impressive
gunsmith, was limited to producing shotgun parts designed and
directed by Miller. Weber is a skilled craftsman and has his own
shop. He was not the inventor and driving force behind the
creation of the custom shotgun. He was not called on to give
expert testimony. The Minister's expert, Mr. M. Bapty, P.
Eng. was a highly qualified mineralogist but he did not have
experience with competition shotguns. It is the position of the
expert witness to provide a comprehensive analysis of the matter
that would permit the Court to arrive at an opinion. No such
analysis was given.
[46] The
Corporation deducted investment tax credits in respect of
qualified expenditures for SRED in connection with its 1993 and
1994 taxation years. In order to calculate the amount of
qualified expenditures, the Corporation broke down the
expenditures between direct, apportioned and overhead costs. The
Corporation allocated a portion of these costs to SRED. The
Corporation claimed 100% of the direct costs, 50% of the
apportioned costs and 5% of the overhead costs. Based on this
calculation, the Corporation claimed investment tax credits in
connection with $26,943.47 and $36,115.97 of qualified
expenditures for its 1993 and 1994 taxation years
respectively.
[47] After
several reviews of the Corporation's claim, the Minister
disallowed the Corporation's 1993 and 1994 investment tax
credits based on the determination that the Corporation's
expenditures did not qualify as SRED expenditures.
Appellant's position
[48] As I
understand it, essentially the Corporation's position is
that: (i) the Minister's expert report is faulty and should
not be relied on; (ii) the expenses claimed with respect to the
Corporation's research projects qualify as SRED expenditures;
and (iii) the percentages for apportioned costs and overhead are
reasonable.
Respondent's position
[49] Counsel
for the Respondent relied on the report prepared by Mr. Bapty.
Based on that report, the Respondent divided the
Corporation's research into two projects for the years in
question: (a) the Custom Stock (1993 and 1994) (also referred to
as the Miller Kwik Change Stocks); and (b) the Receiver-Trigger
(1994) (also referred to as the Convertible Trigger). Mr. Bapty
concluded that there was no eligible activity with respect to the
Custom Stock in 1993 but there was in 1994 and all of the
Receiver-Trigger activity was ineligible.
[50] Mr. Bapty
also submitted the following: (a) not all of the direct costs
were incurred for research purposes; (b) many of the apportioned
costs were not attributable to eligible work under any
circumstance; and (c) some of the overhead was appropriate. The
only guidance provided by Mr. Bapty in his report with respect to
the amount of costs that he considered eligible was the following
statement:
If the project is demonstrated to qualify, some costs are
expected to substantiate the technical improvement. ... I
would accept a limit of $10,000 for all work and testing
....
The Respondent submitted that the equipment repairs and
maintenance costs were appropriate business expenses, if there
was a business, but were not eligible SRED expenditures.
Analysis
[51] As
previously stated, the specifics regarding the SRED claims were
sorely lacking. Counsel for the Corporation based his submissions
on the activities of the Minister and the quality of the
Minister's expert report and not on the requirements for the
eligibility of SRED claims. The Respondent's submissions were
based on the question of whether there was a business or not and
on Mr. Bapty's the report. These submissions, with the
exception of Mr. Bapty's report, did not address the
requirements for expenditures to qualify as SRED
expenditures.
[52] In
Northwest Hydraulic Consultants Limited v. The
Queen,[17]
Bowman J. set out a number of useful criteria in determining
whether a particular activity constitutes SRED. The criteria set
out are as follows:
1.
Is there a technical risk or uncertainty?
(a)
Implicit in the term “technological risk or
uncertainty” in this context is the requirement that it be
a type of uncertainty that cannot be removed by routine
engineering or standard procedures. I am not talking about the
fact that whenever a problem is identified there may be some
doubt concerning the way in which it will be solved. If the
resolution of the problem is reasonably predictable using
standard procedure or routine engineering there is no
technological uncertainty as used in this context.
(b)
What is “routine engineering”? It is this question,
(as well as that relating to technological advancement) that
appears to have divided the experts more than any other. Briefly
it describes techniques, procedures and data that are generally
accessible to competent professionals in the field.
2.
Did the person claiming to be doing SRED formulate hypotheses
specifically aimed at reducing or eliminating that technological
uncertainty? This involves a five stage process:
(a)
the observation of the subject matter of the problem;
(b)
the formulation of a clear objective;
(c)
the identification and articulation of the technological
uncertainty;
(d)
the formulation of an hypothesis or hypotheses designed to reduce
or eliminate the uncertainty;
(e)
the methodical and systematic testing of the hypotheses.
It is important to recognize that although a technological
uncertainty must be identified at the outset an integral part of
SRED is the identification of new technological uncertainties as
the research progresses and the use of the scientific method,
including intuition, creativity and sometimes genius in
uncovering, recognizing and resolving the new uncertainties.
3.
Did the procedures adopted accord with established and objective
principles of scientific method, characterized by trained and
systematic observation, measurement and experiment, and the
formulation, testing and modification of hypotheses?
(a)
It is important to recognize that although the above methodology
describes the essential aspects of SRED, intuitive creativity and
even genius may play a crucial role in the process for the
purposes of the definition of SRED. These elements must however
operate within the total discipline of the scientific method.
(b)
What may appear routine and obvious after the event may not have
been before the work was undertaken. What distinguishes routine
activity from the methods required by the definition of SRED in
section 2900 of the Regulations is not solely the adherence to
systematic routines, but the adoption of the entire scientific
method described above, with a view to removing a technological
uncertainty through the formulation and testing of innovative and
untested hypotheses.
4.
Did the process result in a technological advance, that is to say
an advancement in the general understanding?
(a)
By general I mean something that is known to, or, at all events,
available to persons knowledgeable in the field. I am not
referring to a piece of knowledge that may be known to someone
somewhere. The scientific community is large, and publishes in
many languages. A technological advance in Canada does not cease
to be one merely because there is a theoretical possibility that
a researcher in, say, China, may have made the same advance but
his or her work is not generally known.
(b)
The rejection after testing of an hypothesis is nonetheless an
advance in that it eliminates one hitherto untested hypothesis.
Much scientific research involves doing just that. The fact that
the initial objective is not achieved invalidates neither the
hypothesis formed nor the methods used. On the contrary it is
possible that the very failure reinforces the measure of the
technological uncertainty.
5.
Although the Income Tax Act and the Regulations do
not say so explicitly, it seems self-evident that a detailed
record of the hypotheses, tests and results be kept, and that it
be kept as the work progresses.
In a very brief summary, Mr. Bapty concluded that the work on
the Custom Stock met all the above requirements except he found
that there was no eligible expenditure made in the
Corporation's 1993 taxation year. He also concluded that the
work on the Receiver-Trigger did not qualify since there was no
technical advancement or technological uncertainty. This opinion
was offered without a comprehensive analysis.
[53] Generally
SRED is established by the Court with the assistance of expert
evidence. When all is said, the trial judge chooses one expert
over the other after evaluating their technical evidence. Here we
have a Corporate Appellant who presented no one who qualified as
an expert in the field of competition shotguns. Miller testified
at length. Without doubt he is a skilled shooter as is his son,
who strangely, was not called on to give evidence. Miller knows
shotguns and formulated in his mind what he wanted in a custom
shotgun. He hired Weber, a gunsmith, to carry out his technical
innovations. Together they created the Custom Stock. I find that
this project qualified as SRED and Mr. Bapty also arrived at this
conclusion in his report.
[54] In the
same manner the Corporation caused a technologically advanced
Receiver-Trigger and Recoil system to be built. All were
eventually incorporated in a custom shotgun for which the
Corporation has secured a patent in Canada and the U.S. This
technologically advanced shotgun is presently being marketed.
[55] Although
he described the Receiver-Trigger as a "good piece of
technology", Mr. Bapty concluded that it did not meet the
definition of SRED under Regulation 2900 (1). In reporting on the
Receiver-Trigger, he stated on page 7 of his report:
Receiver-Trigger
Technical Advancement. Two features are claimed, an
exchangeable module which can be quickly replaced if a change or
service is required, a "pull" (standard) or
"release" (the gun fires when the trigger is released)
selection feature. While the work is more complex than the stock
mounting technology, there is no indication of
"technological advancement for the purpose of creating a new
or improving an existing...device, ... including
incremental improvements thereto."
The criterion is not satisfied.
Technical Content. The work advanced from concept to
working prototype to production model in a well defined program,
using a qualified tradesman.
The criterion is satisfied.
Technological Uncertainty. Is not evident in the work
described. In June of 1993 the first Ljutic shotgun was examined
for fitting. The prototype was in service by August of 1993. It
worked from the first firing and did not require a single
modification since the initial installation. In the words of the
gunsmith, "We started with one gun. I look at the parts, I
designed the piece; I built it and tested it. It worked from the
first go. No changes were required."
The criterion is not satisfied.
Going back to the 2900(1) definition, I saw evidence of
"investigation in a field of technology by means of
experiment" but I did not see evidence of "systematic
investigation". The work is indistinguishable from a well
crafted application of known technology.
Passing to the second definition under 2900(1), the
technological advancement required for experimental development
as defined in ss (c) is addressed under Advancement Criterion
above. The incremental improvement in the underlying technology
is not demonstrated, and the work again does not meet the
definition.
I conclude the project does not meet the definition of
SR & ED under the Regulation.
[56] The
evidence presented on behalf of the Corporation has not been
rebutted.. Weber, an impressive gunsmith, demonstrated at the
hearing how he built a Receiver-Trigger from scratch commencing
with a block of steel. I accept Mr. Weber's evidence over
that of Mr. Bapty. Mr. Bapty concluded that the criterion was met
with respect to the Recoil system. While both Miller and Weber
could not be considered expert witnesses and they were far from
being independent, I have no difficulty in concluding that the
Corporation made a prima facie case that was not rebutted
by Mr. Bapty who unfortunately knew very little about competition
shotguns.
[57] The
Respondent submitted that the equipment repairs and maintenance
expenditures in 1994 did not qualify as a SRED expenditure.
Counsel for the Corporation did not address the equipment repairs
and maintenance expenditures in his submission. Since it is
probable that the repairs and maintenance expenses were with
respect to the guns, I find that the deductible amount (i.e 50%
of the amount claimed) of repairs and maintenance expenses
qualify as SRED expenditures at their apportioned amount.
SRED Conclusion
[58] I find
that the Corporation did conduct SRED during its 1993 and 1994
taxation years. However, the amount of the Corporation's SRED
claims should be adjusted to exclude the expenses that I have
found to be personal and not incurred for the purpose of earning
business income. I find that a reasonable apportionment of the
expenditures to SRED is 50% of apportioned costs and 5% of
overhead costs.
Facts of Miller's Reassessments
[59] When
Miller transferred his 50% interest in the software to the
Corporation, he took compensation in the form of relief of his
shareholder loan and relief of his drawings account during the
1992 calendar year. In other words, Miller received compensation
in the form of a credit to his shareholder loan account.
[60] In
reassessing Miller for his 1992, 1993 and 1994 taxation years,
the Minister added $39,350, $44,515 and $6,519, respectively, to
Miller's income as shareholder benefits pursuant to
subsection 15(1). The Minister allocated the amount of disallowed
net expenses of the Corporation's Firearms Division as
follows:
|
Miller's taxation year
|
Corporation's 1993 taxation year
|
Corporation's 1994 taxation year
|
|
|
|
|
|
1992
|
$39,350
|
|
|
1993
|
|
$44,515
|
|
1994
|
|
6,519
|
|
Disallowed net expenses
|
39,350
|
51,034
|
Appellant's position
[61]
Miller's position appears to be that the Corporation's
Firearms Division net expenditures were not personal and that the
application of subsection 15(1) is punitive and not applicable in
this situation.
Respondent's position
[62] The
Respondent's position is that the Corporation paid
Miller's personal expenses with respect to his skeet and trap
shooting activities and in so doing, conferred benefits on Miller
in his capacity as a shareholder. In the alternative, the
Respondent submits that the Corporation conferred benefits on
Miller in his capacity as an employee.
Analysis
[63] It is
unfortunate that the parties did not address in their submissions
the effect on Miller of a finding that the value of the software
was less than the reported $100,000. It is logical, based on my
finding that the value of the software was no more than $100,
that the credit to Miller's shareholder loan account be
adjusted to reflect this. Given the lack of details available, it
is unclear what the effect of this adjustment will be.
[64] Neither
the Respondent nor Miller made submissions, other than passing
comments, on the applicability of subsection 15(1) which
states:
15(1) Where at any time in
a taxation year a benefit is conferred on a shareholder ...
by a corporation ...
the amount or value thereof shall ... be included in
computing the income of the shareholder for the year.
The scope of subsection 15(1) is very broad and is applicable
when a benefit is conferred by a corporation on a shareholder
qua shareholder.
[65] Miller
submitted that the expenses paid by the Corporation were with
respect to a business purpose and not personal. I have found
under the Firearms Division issue that some of the expenses paid
by the Corporation were personal.
[66] The
Minister relied on the assumption that the Corporation conferred
a benefit on Miller in his capacity as shareholder. Miller did
not meet his onus in disproving the Minister's assumption. I
find that the personal expenses paid by the Corporation (the
disallowed expenses as determined under the Firearms Division
issue) are a benefit conferred on Miller as shareholder and are
to be included in his income pursuant to subsection 15(1).
Consequently, the appeals of Miller are dismissed.
Conclusion
[67] In light
of the manner in which the amounts were presented, I will not
begin to get into the accounting in this case. I rely on both
parties to work out the amounts based on my reasons and if the
parties cannot come to an agreement, the parties may make
submissions for my determination.
[68] In
summary, the appeals of Miller from reassessments of tax for the
1992, 1993 and 1994 taxation years are allowed on the basis that
in computing income, Miller is entitled to deduct those business
expenses set out under the Firearms Conclusion. The appeal of the
Corporation from the reassessment for the year ending February
29, 1992 is dismissed because no issue was brought forward with
respect to 1992, and the appeal of the Corporation from the
reassessment for the years ending February 28, 1993 and 1994 is
allowed and the reassessment is referred back to the Minister of
National Revenue for reconsideration and reassessment in
accordance with the foregoing reasons.
[69] The
Respondent is entitled to costs in these appeals as if there were
only one Appellant.
Signed at Ottawa, Canada, this 2nd day of January, 2001.
"C.H. McArthur"
J.T.C.C.
Email this Content