Reginald Watson and Deborah Madayag v. Her Majesty the Queen, [1995] 2 CTC 2460, 96 DTC 2006

Hamlyn J.T.C.C.:-These appeals, for the 1987 taxation year, while separately constituted were heard together at a sitting of this Court at Vancouver, British Columbia.

Each appellant reported in their individual income tax returns business losses on the basis that they incurred expenses (with minimal offsetting income) in the course of carrying on an alleged magazine publishing business: Enjoy Magazine ("Enjoy"). The Minister of National Revenue (the "Minister") by notices of assessment disallowed the business losses claimed by the appellants. The appellants objected to the assessments by notices of objection and the Minister confirmed the assessments by respective notices of confirmation.

The appellants’ respective positions are that the expenses were incurred by the payment of licence fees, professional fees, interest and advance royalties pertaining to the publishing of Enjoy. The appellants assert the expenses were paid in order to derive income from the publishing of Enjoy.

The Minister maintains the appellants, for the relevant taxation years, did not carry on a business of publishing and distributing magazines, and in the alternative, if there were a business it did not have a reasonable expectation of profit. Further, if the appellants are found to have a reasonable expectation of profit from the alleged business the amounts were unreasonable in the circumstances and are therefore not deductible. Lastly, the Minister pleaded if the deductions were allowed such deductions would unduly or artificially reduce their respective incomes because the transactions giving rise to the claimed deductions were shams and as such the deductions are prohibited by the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the ’’Act”).

Facts

Both appellants bought licences through H.N. Thill & Associates Inc. ("Thill") from Applied Research Ltd. ("Applied") to permit them to publish, distribute and market Enjoy within a licensed territory in the U.S.

Applied owned a copyright to Enjoy. Thill acted as an agent for Applied for the purpose of promoting the sales of licences to publish Enjoy.

Under the terms of the agreement between each appellant and Applied, the appellants were to pay to Applied for each territory acquired a licence fee ($500 U.S.) and an advance royalty ($15,000 U.S.).

Of the moneys owing, the appellants were only required to pay the $500 licence fee out of their own funds. The balance of the funds were borrowed from Federated Financial Corporation ("Federated") by way of promissory note.

Each appellant entered into an operating agreement with Plymouth Publications Inc. ("Plymouth") to publish, distribute and market Enjoy in the territory. Plymouth agreed to pay the appellants 12.5¢ U.S. per copy of Enjoy distributed within the territory during the term of the agreement (one year subject to renewal). To guarantee the contractual performance, Plymouth executed and deposited a performance bond with Federated in the amount of the promissory note to Federated. Thus, in the marketing scheme of things in the event of non performance, the performance bond would offset the promissory note and the appellants would be saved harmless (see Exhibit A-2).

The net result of the transactions for the appellants was they contributed $500 for each territory acquired; however, in the view of Thill for the taxation year in question each appellant was entitled to deduct as business expenses the licence fee, the advance royalty payment and other costs. As in that year there would be little business income and negligible royalties to offset the acquisition costs a loss would be created and reported by each appellant.

Thill, as well as the preparer of the income tax returns for the appellants, was also in the business of marketing tax shelters. The scheme the appellants bought was developed and marketed by Thill.

The appellants bought the licences in March 1987 without any investigation and did nothing in terms of business activity after the purchase and relied on Thill to look after the matter.

Thill created a corporate circuit and transaction structure behind the tax scheme that was similar to Moloney v. Canada, [1989] 1 C.T.C. 213, 89 D.T.C. 5099 (F.C.T.D.); aff’d by [1992] 2 C.T.C. 227, 92 D.T.C. 6570 (F.C.A.), at page C.T.C. 228, D.T.C. 6571.

The scheme was comprised of the following companies:

-Applied (licensor and receiver of licence fees and advanced royalties)

-Plymouth (publisher, marketer, distributor of Enjoy, issuer of performance bonds)

-Federated (financial vehicle-holding of deposits of performance bonds, receiver of promissory notes and issuer of advanced royalty cheques to appellants endorsed to Applied)

—Cawin Financial Corporation ("Cawin") (financial vehicle-conduit of funds)

-Thill (promoter and marketer of tax scheme)

The book entries between the forgoing companies and the appellants gave an appearance of a large circulation of funds that in essence was a recycling of funds.

The Plymouth deposits with Federated of performance bonds is an example of the circuitous flow of transfers and is shown in Exhibit R-l 1. The transfers occurred all in one day and followed this pattern: Plymouth to Federated, Federated to Cawin, Cawin to Plymouth (Exhibit R-l 1).

The facts are further that Plymouth did develop a prototype Enjoy, bought market surveys, established offices in Burnaby, San Francisco, Los Angeles and New York, set up an apparent structure to sell advertising in the magazine and did produce and partially distribute one run of the magazine. In actual fact for the one issue of Enjoy the advertising in large part was given away and little revenue was produced.

The magazine was to be distributed without charge to selected markets that Plymouth thought the subject matter would appeal to (recipes, cooking and related information).

The plan was originally to distribute in one selected area copies of the magazine. This plan during the development changed whereby the magazine was to be distributed to 29 selected markets throughout the U.S. with a proposed annual circulation of 3,900,000 (650,000 homes x 6 times-Exhibit A-4). While this circulation number results from Exhibit A-4, other circulation numbers were presented to the Court in excess of this amount.

The magazine was printed in Vancouver and taken to a post office in Seattle for distribution.

After the initial partial distribution (127,000 copies) Thill cut off the funds to Plymouth and Plymouth was unable to continue.

The appellants received credit for an apparent royalty payment and an advertising payment that could not be reconciled with the print copies or the distributed copies of Enjoy and the income the appellants purportedly received could not be reconciled with the stated advertising revenue from Enjoy; these calculations were prepared by Thill.

After the failure, Thill issued a form letter dated May 11, 1989, to each appellant "Dear client" stating Plymouth released all claims against the deposit (performance bond) with Federated and Federated has accepted the deposit funds as full and final settlement of the promissory notes issued by the appellants to Federated (Exhibit A-2).

Significant evidence

Reginald Watson

Mr. Watson, one of the appellants, purchased his licence through one Ken Holloway of Thill. Thill was the tax return preparer for Mr. Watson. His understanding of the licence was minimal. He stated he signed the documents but he did not understand what was in them.

He knew it was a magazine proposal that he could invest in, that he felt had a potential to provide him with a retirement income, and that had present tax reduction advantages. His total cash outlay was $500.

In terms of business activity, before and after signing the documents he did nothing. His investigation was non existent save he thought about the proposal for a couple of days. He had a history of buying other proposed "tax shelters" from Thill on other occasions.

Deborah Madayag

Ms. Deborah Madayag, the other appellant, purchased the licence in similar circumstances as Mr. Watson. However, she signed on when it was proposed to her without an intervening review period. She believed the proposal was primarily in her words a "tax deferral" and "it was good for my taxes" and she stated it would provide a possible future income. Ms. Madayag also had little or no idea what was really happening and simply followed the advice of Mr. Holloway.

Henry N. Thill

Mr. H.N. Thill, the next witness, was the operating mind behind this scheme. For the period in question, he was a director with Messrs. Wilson, Sinclair and Cop of Applied and held the power of attorney for Applied in Canada. For Thill he was a director along with Messrs. Wilson, Sinclair and Cop. For Cawin, he was an initial subscriber; thereafter the sole shareholder of Cawin was Applied and as indicated Mr. Thill held the power of attorney for Applied in Canada. The directors of Cawin were the same as the directors of Thill save Mr. Thill. For Plymouth, Mr. Thill was a director as well as others including Mr. John Frederickson. For Federated, Mr. Thill was a director as well as Messrs. Wilson, Sinclair and Cop and others.

Mr. Thill styled himself as a business executive in the business of tax practice and financial planning. He outlined to the Court the plan he developed with one Gerry Pionski (the major shareholder of Applied) to develop and publish a magazine, and distribute it to a controlled circulation (selected area—non-paid circulation) with the object of earning revenue from advertising. The scheme as described above included the selling of a licence by Thill to Thill clients by having the clients pay a fee for the licence and executing a promissory note for advance royalties. (Thill was to receive $100,000 per month as a retainer fee from Applied.) A performance bond was provided by the magazine publishing and marketing vehicle (Plymouth).

As indicated the monies, promissory notes and performance bonds took a circuitous route through the myriad of companies.

Mr. Thill maintained Plymouth had a business plan and carried through with planning, development, marketing, production and distribution of the magazine.

According to Mr. Thill, the enterprise failed because of development cost overruns, managers not performing, and in particular the failure to sell advertising. During the course of the development stage as indicated the plan was redeveloped to change the magazine from a regional market (San Francisco) to a national United States selected areas market. Mr. Thill concluded that Plymouth did not produce as expected.

Of the only issue of Enjoy 650,000 copies of the magazine were printed, and 127,000 were distributed and the balance stayed in a warehouse in Seattle until destroyed.

Mr. Thill stated that Thill took the decision to not circulate the balance of the magazine as they considered the enterprise had failed and cut Plymouth off from the source of funds.

As one of the principals involved in the Moloney, supra, "speed reading" case Mr. Thill was asked what was the difference between the two tax schemes. He stated that in this case, with respect to Plymouth, a business had been started and a magazine distributed.

In response to the allegation that the transfers through the separate corporate current accounts offset one another and that none of the companies could negotiate large cheques without receiving a deposit for a similar amount on the same day, Mr. Thill stated he operated on the "just in time" principle and that no cheque was dishonoured.

Mr. Thill maintained he could find the financing throughout from his several sources including Applied, "Eurobank Grand Cayman", "Bank of Bermuda” and private loans.

On cross-examination, Mr. Thill’s evidence in terms of his involvement in the actions and details with the companies within the Thill tax scheme before the Court, was at times contradictory with documentary evidence and his responses when confronted with the documentation did not clarify matters.

John Frederickson

Mr. Frederickson was hired to plan, develop, produce and market Enjoy.

The concept plan was given to him by Mr. Thill. The thrust and direction of Mr. Thill was that he wished to create a tax shelter by the development of Enjoy.

Mr. Frederickson who was experienced in advertising amongst other things, followed directions and developed projections to produce a "deluxe” magazine product that would cost $3-4,000,000 in the first year. Mr. Thill assured Mr. Frederickson that financing was not a problem.

All Mr. Frederickson had to do, according to what Mr. Thill said, was call Thill for funds.

The progress continued as described until funds were cut off by Thill. Mr. Frederickson’s first indication of this was when he was advised a cheque taken to Seattle to pay for postage had been dishonoured. Mr. Thill stated that the enterprise had cost Thill $1,700,000; however, no evidence was tendered to confirm this. When Plymouth ceased operating there were apparently $500,000 in unpaid bills.

From time to time during Mr. Frederickson’s employment, his services were used in relation to the selling of licences.

Mr. Frederickson stated at no time was there an expectation that the first, second or third issue of the magazine would break even. He said he thought it might break even by the fourth issue. He never got the chance to find out.

Bill Sulis

The first witness for the respondent was an auditor with Revenue Canada, Mr. Sulis, who examined the corporate books and records of the companies involved. His conclusions on the corporate fund transfers within the tax scheme remain unassailed.

Firstly, the recorded transaction transfers (e.g., funds transferred from Plymouth to Federated as deposits for performance bonds were transferred to Cawin and back to Plymouth on the same day) among the corporations in the tax scheme had the effect of giving an appearance of increased assets and increased liabilities for all the corporations. Secondly, the cheques from Federated endorsed by the licensees and redeposited to Federated on the same day showed the payment of prepaid royalties by the licensees and created promissory notes receivable on the books of Federated without the expenditure of funds by either party, save the small licence fees paid by the clients. Thirdly, none of the companies involved was capable of negotiating the large cheques recorded without receiving a deposit for a similar amount the same day. Fourthly, the capitalization in relation to the enterprise purported to be carried on was not sufficient.

Janet Dulk

The last witness was Janet Dulk, an appeals officer with Revenue Canada. She responded to an advertisement entitled "Tax Planning Seminar-Tax Shelters are not Dead", spoke by telephone with Mr. Frederickson and found herself (December 1, 1986) at the offices of Thill. There she heard a lecture from Mr. Thill and talked with Mr. Holloway. The information received related to Enjoy, the projected circulation of 650,000 copies and how the licence could be acquired including the financing of the advanced royalties.

Legislation and jurisprudence

Computation of loss from a business

Section 3 of the Act sets out the rules to determine a taxpayer’s income. A business loss is taken into account by virtue of paragraph 3(d) which states that any positive amount determined under paragraph 3(c) is reduced by "the aggregate of all amounts each of which is his loss for the year from...business."

The provisions of the Act that apply to the computation of a loss from a business are those that apply to the computation of income from a business, or in the words of subsection 9(2):

9(2) a taxpayer’s loss for a taxation year from a business or property is the amount of his loss, if any, for the taxation year from that source computed by applying the provisions of this Act respecting computation of income from that SOUICE....

The general provision of the Act for calculating business income (and therefore a business loss) is subsection 9(1) which states that:

9(1) a taxpayer’s income for a taxation year from a business or property is his profit therefrom for the year.

In calculating this profit (or loss) paragraph 18(1 )(a) stipulates that no deduction shall be made in respect of:

18(1)(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property.

Even if an outlay or expense is made for that purpose, it still is subject to the general limitation of section 67 that:

no deduction shall be made in respect of an outlay or expense ... except to the extent that the outlay or expense was reasonable in the circumstances.

For the taxation year in issue, the version of subsection 245(1) that applied also disallowed deductions made:

in respect of a disbursement or expense made or incurred in respect of a transaction or operation that, if allowed, would unduly or artificially reduce the income.

Meaning of business

In any event, a loss from a business presupposes that there is a business. Subsection 248(1) gives an extended definition of "business" as including

a profession, calling, trade, manufacture or undertaking of any kind whatever and...an adventure or concern in the nature of trade....

However, in this case, it is the ordinary meaning of "business" which is relevant. In Moloney, supra, it was noted at pages C.T.C. 227-28, D.T.C. 6570 that for an activity to be a business it must produce income in its own right and not merely from applying the Act:

While it is trite law that a taxpayer may so arrange his business as to attract the least possible tax [1] , it is equally clear in our view that the reduction of his own tax cannot by itself be a taxpayer’s business for the purpose of the Income Tax Act. To put the matter another way, for an activity to qualify as a "business" the expenses of which are deductible under paragraph 18(1 )(a) [2] , it must not only be one engaged in by the taxpayer with a reasonable expectation of profit, but that profit must be anticipated to flow from the activity itself rather than exclusively from the provisions of the taxing statute.

More recently, in Bendall v. Canada, [1995] 2 C.T.C. 2172 (T.C.C.), this Court addressed the meaning of business. Judge Bonner wrote:

The issue here is whether the appellant carried on a "business" within the meaning of the Income Tax Act. That word is to be given its ordinary meaning [3] and that meaning does not include a tax avoidance scheme which is nothing more than a pale imitation of a business. The appellant was not involved in a commercial activity either directly or through Omni as his agent. The objective evidence regarding the manner in which the scheme operated and the actions and inaction of the parties point clearly to a conclusion that both the appellant and the promoters of the scheme were indifferent to the marketing of the speed reading course and to the earning of profits from that activity. There can be no doubt that what was sought was a tax deduction which would result in a refund part of which was to go to enrich the promoters of this scheme and the remainder of which was to go to the appellant. I disbelieve the appellant’s testimony as to his subjective intention. As noted in Symes, E.C. v. Canada, [1993] 4 S.C.R. 695, [1994] 1 C.T.C. 40,94 D.T.C. 6001, per lacobucci J., at page 736 (C.T.C. 58; D.T.C. 6014):

As in other areas of law where purpose or intention behind actions is to be ascertained, it must not be supposed that in responding to this question, courts will be guided only by a taxpayer’s statements, ex post facto or otherwise, as to the subjective purpose of a particular expenditure. Courts will, instead, look for objective manifestations of purpose, and purpose is ultimately a question of fact to be decided with due regard for all of the circumstances.

In my view the deduction of the component elements of the "losses" is prohibited by paragraph 18(1 )(a) of the Act.

The ratio of the decision of the Court of Appeal in Moloney is contained in the following passage at page 6571 :

In our view the judgment under appeal is based on the trial judge’s findings of fact, notably that the appellant never intended to carry on the business of marketing the speed reading course himself or through Omni, that neither the appellant nor Omni had the means or the ability to do so, and that the sole purpose of the scheme was to obtain tax refunds and nothing else.

That decision is none the less applicable despite the absence in this case of evidence showing the "circularity and simultaneity of the transactions between the related companies". The essential facts in this case and in Moloney are the same. I will therefore dismiss the appeals with costs.

Analysis

The appellants primarily bought a tax reduction scheme. The assertion that an investment of $500 would provide retirement or future income does not stand the test of reality. The appellants did nothing other than sign documents and pay the licence fee. No investigation took place by them, no research was conducted by them, no business plan was developed by them and certainly they made no efforts to operate a business.

The activities of Thill and Plymouth beyond the limited appellants’ efforts necessitate examination because of the operating agreement between Plymouth and the appellants.

I conclude that the operating mind behind the scheme was Mr. Thill. Because of his interrelationships with the corporations and the individuals involved, this fact leads to a conclusion that the relationships among Applied, Cawin, Thill, Federated and Plymouth were at non-arm’s length and Mr. Thill and Thill controlled the tax scheme throughout.

The tax scheme is essentially the same as that before the Court in Moloney, supra, and the Federal Court of Appeal has pronounced on that.

As to the development, production and distribution of Enjoy by Plymouth, from the evidence, I conclude there was insufficient capitalization to undertake the business proposal that was outlined. Moreover, there was no documentary or other evidence to support the assertion of Mr. Thill that sufficient capital was always available. In any event, either way, insufficient capital or unlimited funds, the control actions of Thill lead to a conclusion that profit was not the objective of Plymouth.

The activities of Plymouth were directed to enhance the marketing activities of Thill in the selling of licences and not per se to represent the appellants’ business under the licences.

The fact that Plymouth forfeited the performance bonds and that Federated forgave the promissory notes from the appellants supports a conclusion the activity was that of a tax scheme and not that of a business of developing, publishing and distributing a magazine.

The paper entries on the books created an aura of a substantial enterprise without any real substance behind it. This illusion brings into doubt the veracity of the amounts alleged to have been expended on Plymouth by Thill. The continued marketing of the licences and the renewal of the licences after the project had failed (appellant Madayag), the payment of royalties far in excess of what copies of Enjoy had been printed and farther still in excess of what was distributed, the payment of income that could not be reconciled with the advertising revenue, and the ceasing of funding after the initial issue run are all indicia of a scheme to create the impression of a business rather than a business. Moreover, I conclude the actions of Thill in view of the evidence of Mr. Frederickson-that he told Mr. Thill what was really involved and the costs to expect ($3—4,000,000) and Mr. Thill’s direction to carry on are consistent with an inference the enterprise was designed and destined to fail. No business was carried on by Plymouth or Thill that enured to the benefit of the appellants.

Specifically, I conclude that the fact of the publication of one issue of Enjoy given the findings herein does not bring this case outside the Moloney, supra, decision.

The assumptions of the Minister have not been dislodged.

I therefore conclude the alleged expenses reported by the appellants are not deductible within the meaning of paragraph 18(l)(a) of the Act.

The appeals are therefore dismissed with costs.

Appeals dismissed.