Barry J. McHugh, Barbara L. McHugh, Inland Development Company Limited, McHugh Minerals Limited v. Her Majesty the Queen, [1995] 1 CTC 2652, 95 DTC 778

McArthur J.T.C.C.:-Appellants Barry J. McHugh and Barbara L. McHugh have appealed their income tax assessments for the 1981, 1982, 1983 and 1984 taxation years. Inland Development Company Ltd. ("IDCL") has appealed its income tax assessments for the same years as well as for the 1985 and 1986 taxation years. McHugh Minerals Ltd. ("MML") has appealed from reassessments of its 1982, 1983 and 1984 taxation years. The appeals were heard on common evidence upon consent.

In reassessing Barry J. McHugh and Barbara L. McHugh for the taxation years 1981, 1982, 1983 and 1984, the respondent added certain amounts to their income, pursuant to subsection 15(1) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (the "Act”). Subsection 15(1) of the Act provides that where, in a taxation year, a benefit has been conferred on a shareholder by a corporation, the value thereof shall be included in computing the income of the shareholder for that year. The shareholder benefits in question pertain to meals, travel and promotion expenses (client entertainment expenses) paid by IDCL and MML, a standby charge for a condominium residence in Palm Desert, California owned by IDCL and used by the McHughs (herein the "Palm Desert property”) and maintenance expenses on a home in Calgary, Alberta paid by IDCL and MML and used by the McHughs as their principal residence. The benefits assessed by the respondent are detailed below in Schedules "A”, "B” and ”C”.

The respondent also reassessed Barbara and Barry McHugh on the basis that they received a shareholder benefit pursuant to subsection 15(1) of the Act with respect to a property purchased by IDCL from the appellants’ daughter and son-in-law below fair market value. A deemed interest benefit for the 1982, 1983 and 1984 taxation years was included in their income. These issues, and others, were eventually settled and dealt with through the presentation of consents to judgment.

In reassessing the two corporations the respondent disallowed the deduction from income of the same expenses assessed as benefits on the McHughs, and other expenses claimed, on the basis that they were not incurred for the purposes of gaining or producing income from the business or property within the meaning of paragraph 18(1)(a) of the Act. Regarding IDCL, the expenses in issue include: travel and promotion expenses; interest expense on the Palm Desert property; repairs, maintenance and other expenses on this property as well as on the home in Calgary used by the McHughs as their principal residence; dues and subscription expenses and finally, capital cost allowance claimed on the Palm Desert property.

With respect to MML, certain maintenance, repairs and property tax expenses relating to the Calgary house were apparently in dispute but are accepted as having been settled. Expenses still in issue are those relating to travel and promotion. The latter are in effect, meals and client entertainment expenses paid by MML and incurred by the McHughs allegedly in their capacities as officers of the company.

The Minister of National Revenue (the "Minister") also assessed penalties for taxation years 1982, 1983 and 1984 pursuant to subsection 163(2) of the Act on the basis that the appellants knowingly, or under circumstances amounting to gross negligence, participated in, assented or acquiesced in the making of false statements or omissions in their relevant returns.

Facts

Mr. Barry McHugh provided a comprehensive history of his early business years. He had gained broad experience during the 1960s in the natural gas and oil industry particularly as a "land man" in exploration. He worked for major oil companies including Mobile Oil and Scurry Rainbow in Alberta and Saskatchewan.

In the late 1960s, he incorporated MML and IDCL was incorporated several years later. He and his wife have been directors and president and vice-president respectively from the date of incorporation of the companies to the present. The McHughs are the sole and equal shareholders of both companies, IDCL and MML, which are both taxable Canadian corporations. MML commenced as a land broker, securing and conveying leasehold and freehold interests in properties to the oil and gas industry. As that company grew, IDCL was incorporated to develop properties, predominately by drilling and operating with partners. These properties were natural gas wells in an area north of Edmonton, Alberta described as Thorehill, Nestaw and Abii. The bulk of IDCL’s income and retained earnings, are derived from those three producing natural gas wells. These wells produced substantially all of the income of the appellant IDCL during the relevant taxation years, with oil and gas income averaging in excess of $400,000 annually over the four years in question. IDCL complemented MML by developing those lands designated by MML.

Over the years, the companies explored and took interest in a variety of business ventures that included oil shales in northern Saskatchewan, a new pipeline to southern California, a restaurant and commercial real estate in Hawaii, synthetic oil from Mexican jojoba bean, coal deposits, a mining operation described as "Flin Flon". A total of approximately $48,000 was advanced to retain a leasehold interest in the northern Saskatchewan oil shale lands, over a ten-year period. This was the only substantial monetary advance made towards these outside ventures.

A third company, Economic Development Corporation ("EDC") was incorporated under the laws of the State of Nevada, U.S. as a wholly owned subsidiary of IDCL. It explored for mineral deposits in western U.S. and drilled in search of silver and gold in the Nevada Desert during 1983. EDC borrowed approximately $180,000 from IDCL to pursue its objects. EDC had been relying on the Flin Flon mining operation to exploit the EDC (Churchill) Nevada property. The results of EDC’s drilling operation were marginal. Flin Flon declared bankruptcy and EDC abandoned its Nevada efforts. IDCL stood to profit from EDC’s success pursuant to an agreement between the two companies dated February 15, 1982. Liberally interpreted, it provided that EDC would invite IDCL to participate in investment proposals procured by EDC. EDC never repaid the money borrowed from IDCL.

During 1983 in particular, Mr. Barry McHugh was active in the western U.S., particularly in Nevada and California, in the preparation and supervising of the considerable efforts of EDC in searching and drilling for mineral deposits. In addition to the EDC pursuits, Mr. McHugh continued to look for oil and gas ventures and markets for IDCL’s natural gas particularly in southern California.

There was considerable evidence produced with respect to the EDC Nevada drilling operation that obviously took up much of Mr. McHugh’s time particularly during the 1983 winter months. Further time and travel expenses were required for the dismantling and sale of the EDC assets after the (Churchill) Nevada project was abandoned.

Mr. McHugh demonstrated extraordinary determination and a self- confident conviction, in his efforts to generate interest amongst his independent oil and gas producer colleagues and large corporate interest groups to construct a gas line from the producing areas of western Canada to southern California. These endeavours did not come to fruition. Although the major work appeared to have occurred in the latter half of the 1980s, he did begin preliminary efforts which included meetings and attendances in California during the relevant taxation years.

Mr. McHugh made efforts on behalf of IDCL and EDC towards finding new markets for IDCL’s surplus gas that was not purchased by TransCanada PipeLines. In generality, he described attending business meetings particularly in the southern California area, in the aim of gaining the interest of large corporations in participating in a multi-billion dollar pipeline. There were two existing lines into southwestern U.S. He did not appear to have invested a substantial amount of money into his pipeline efforts during the relevant years, other than what is described as travel and promotion.

In January 1980, IDCL purchased the residential condominium in the city of Palm Desert, California, allegedly to serve as a base of operations for the U.S. aspects of the business. Mr. and Mrs. McHugh lived at the Palm Desert property through the winter season, approximately five months of the year during the years in question. Between January 1981 and January 1984, when the condominium was sold, IDCL incurred expenses in maintaining the property. These expenses include interest, property taxes and repairs and maintenance expenses. Mr. McHugh described the Palm Desert property as representing IDCL’s presence in the U.S. The property was within close proximity to Los Angeles where the utility companies are located and also close to Nevada where EDC had its drilling operation. A small area of the Palm Desert property was converted to an office space and Mrs. McHugh used her interior decorating skills to tastefully decorate and furnish the entire unit. Mr. McHugh stated that the condominium was used primarily for business purposes where he carried on IDCL and EDC’s activities and entertained business guests. Mrs. McHugh took care of the office responsibilities in his absence. He felt the condominium was a reasonable prestigious demonstration of his company’s seriousness in its U.S. endeavours.

He testified that during the years in issue, he met with officials of several utility companies, also with individuals who could supply products needed for the proposed pipeline and others in southern California. He used the services and facilities of the Alberta Government’s office in Los Angeles. He gathered statistical information on many aspects pertaining to his pipeline plans and obviously pursued his objectives while residing at the Palm Desert property. There were some specifics as to people he met, when, where and why, but for the most part the evidence in this regard was very general if not vague. He stated that most of his time in California during the taxation years 1981 through 1984 were occupied in business pursuits, including finding markets for IDCL’s excess gas, gaining support for a new pipeline, developing synthetic fuel through the Mexican jojoba bean and EDC exploration. He described these efforts as missionary work, or doing your homework. Evidence of Mrs. Barbara McHugh and son Barry McHugh supported Barry McHugh’s evidence and expanded upon it.

Mr. and Mrs. McHugh also travelled to Hawaii where Mr. McHugh apparently investigated the purchase of a commercial real estate property and a restaurant. IDCL paid for an exploratory trip by the McHugh’s daughter and son-in-law to Nevada.

With respect to the home in Calgary, both corporations incurred expenses for this house, owned jointly by Mr. and Mrs. McHugh at 2926 Montcalm Crescent, Calgary, Alberta and used as their principal place of residence. Prior to 1980, approximately 1,000 square feet of the lower area of the Calgary principal place of residence, was converted into office space for IDCL and MML. The companies paid utility and maintenance expenses in lieu of rent. It would appear from the minutes of settlement that the parties have ended their dispute regarding the expenditures on utilities, maintenance, repairs and property taxes on the Calgary house paid by MML. The same expenditures paid by IDCL do not appear to have been

settled.

Other IDCL expenses included the cost of an annual stampede party held at the Calgary residence. Also, travel and other related expenses incurred on a trip to Vernon, British Columbia to protect IDCL’s investment in a single family residence occupied by the daughter and son-in-law of Mr. and Mrs. McHugh.

For the most part, the aggregate amounts at issue were contained in schedules to IDCL’s, Barry McHugh’s and Barbara McHugh’s notice of appeal. The amounts still in issue are listed below in Schedules "A", "B" and "C". The amounts in issue with respect to MML’s reassessments are minor in comparison.

[Schedules not reproduced. I

For MML, the amounts remaining in issue pertain only to travel and promotion expenses disallowed in the amount of $3,543 for the 1982 taxation year and $757 for the 1984 taxation year.

Position of the appellant

Dealing with the corporate appellants first, it 1s submitted that the expenditures incurred by these appellants during the relevant taxation years, described in items Al and A3 to A6 above in the Schedule "A" regarding IDCL, and those described above concerning MML’s appeals, were made or incurred by these appellants for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1)(a) of the Act. Those expenses for travel and promotion, repairs and maintenance on the Palm Desert property as well as on the house in Calgary, property taxes on the Palm Desert property, telephone and utilities expenses and dues and subscription expenses were made in order to permit the companies to pursue their U.S. and Canadian business activities. As such, they are deductible in the computation of the corporations’ income from a business or property for the relevant taxation year for purposes of subsection 9(1) of the Act.

The maintenance expenses relating to the home maintained at 2926 Montcalm Crescent in Calgary were allegedly made in lieu of payment of rent to the appellants who were the joint owners of the home. It is alleged that the companies, that is IDCL and MML, used and occupied a portion of this home, which was in fact also the residence of the appellants, for the conduct of business. The companies paid maintenance expenses, as well as telephone and utilities expenses.

The Palm Desert property was acquired, it is argued, in order to serve as a base of operations for the U.S. aspects of the business. In particular, it is argued, that the U.S. office of each of IDCL, MML and EDC was maintained at the Palm Desert property. It 1s also submitted that during the period that IDCL owned this property, the U.S. business activities of the companies required the presence of the McHughs in the U.S. on a regular basis and the Palm Desert property served as accommodation for the appel- lants during the time they were in California. As a result, the cost of the condominium was incurred in order to allow the appellants to carry on the business activities of the companies. The appellants also argue that the maintenance expenses relating to the Palm Desert property were incurred by IDCL in order to allow the corporate appellants to carry on the U.S. business activities of the companies. The money borrowed by IDCL to acquire the Palm Desert property was used for the purpose of earning income from a business or property and therefore the interest expense incurred in respect thereof for each of the 1982, 1983 and 1984 taxation years, described in item A2 of the Schedule "A" above, was deductible by the appellant pursuant to paragraph 20(1 )(c) of the Act.

The decisions to incur these expenses were ultimately made by the appellant, Barry McHugh as officer of IDCL and MML. It was as a result of his hands-on approach, his exercise of judgement in risk taking and undertaking various initiatives that the companies were so successful. Part of appellant counsel’s argument may be summarized in a quotation he cited from Nichol v. The Queen, [1993] 2 C.T.C. 2906, 93 D.T.C. 1216 (T.C.C.) by Bowman J.T.C.C. at pages 2908-09 (D.T.C. 1218):

I do not think that it is appropriate for the Minister of National Revenue, who is quite ready to share in the success of an enterprise, to deny the deduction of losses where, with the benefit of hindsight, he considers that the taxpayer should have foreseen that his project would fail.

Secondly, with respect to the individual appellants, Barbara and Barry McHugh, counsel argued that while there was some personal element, for the most part, they did not receive personal benefits assessable as income relating to the meals, transportation or client entertainment expenses paid by IDCL and MML, or relating to the use of the Palm Desert property and the payment of certain repairs and maintenance expenses on the Calgary house. It is alleged that these expenses were made in order to allow the MCHughs in their capacities as officers of IDCL and MML to carry on the U.S. and Canadian business activities and for the purpose of earning income for the corporate appellants. It was originally argued that the McHughs did not receive or enjoy a benefit of any kind assessable in income as a result of their use of the Palm Desert property. However, during the course of the hearings, the appellants conceded that the expenses may have both a personal and business component which are interconnected and if a shareholder benefit must be assessed against the McHughs, then it should be calculated on the basis of actual use.

The appellant referred to the decisions rendered in Houle v. M.N.R., [1983] C.T.C. 406, 83 D.T.C. 5430 (F.C.T.D.), Giffin et al. v. M.N.R., [1991] 1 C.T.C. 2306, 91 D.T.C. 421 (T.C.C.), Check et al. v. M.N.R., [1987] 1 C.T.C. 2114, 87 D.T.C. 73 (T.C.C.) and Dudelzak v. M.N.R., [1987] 2 C.T.C. 2195, 87 D.T.C. 525 (T.C.C.) in support of the proposition that where the property is purchased for both corporate and personal use, the benefit to the shareholder should be computed on the basis of actual use by the shareholder. Counsel for the appellant also referred to an article published by the Canadian Tax Foundation in the Forty-Second Conference Report at pages 4:37 and 4:38 and quoted the following[1] :

In several cases decided by lower courts, however, the purpose of the company in acquiring the property has been found to be determinative of this issue. Where the primary purpose of the company in acquiring the property was determined to be a business purpose (and the personal benefit of the shareholder was incidental to that purpose), the fair market value rent (to the extent only of the actual personal use) or a proration of the company’s operating costs (based on the percentage of actual personal use) has been found to be the appropriate measure of value. Where the primary purpose of the company in acquiring the property was determined to be the personal benefit of the shareholder (and a business purpose was either non-existent or incidental), the appropriate measure of value has been found to be the entire cost to the company of providing the benefit or the fair market value rent for the entire period in which the property was made available to the shareholder.

Counsel for the appellant argued that there was a business purpose to the expenditures incurred by the corporation in respect of the condominium and that the evidence indicates that it was only from November 1 to April 1 of each year in question, less two weeks over the Christmas period, which should be taken into account when computing the personal benefit to the McHughs. Only that actual use should be taken into account when calculating any benefit.

Counsel for the appellant then argued that as a result of the business use of the properties there should be an apportioning between business and personal use even for the five-month period of use. For example, the appellant suggests that only 50 per cent of the use of the corporate properties during those five months should be attributed to personal use. The Potvin et al. v. M.N.R., [1990] 2 C.T.C. 2381, 90 D.T.C. 1644 (T.C.C.) decision was referred to in support of this proposition. In this latter case, the taxpayers were managing two apartment buildings and under the terms of their contract, they were obliged to live in a suite in one of the buildings, but were permitted to do so on a rent-free basis. Christie J.T.C.C. held that the amount of the income benefit that should be assessed was 25 per cent rather than 70 per cent.

Respondent"s position

With respect to the Palm Desert property, the maintenance and property tax expenses for this property, the meals, transportation, client entertainment expenses, and finally, the maintenance expenses for the Calgary home were all personal living expenses of the appellants, Barry and Barbara McHugh and were not business expenses of IDCL and MML. As a result, Barry and Barbara McHugh received benefits in their capacities as shareholders of IDCL and MML. The McHughs, it is argued, should also be assessed a benefit for the standby use of the corporate property.

With respect to IDCL, the Minister states that the expenses claimed by IDCL in Schedule "A" were not incurred for the purposes of earning income. Palm Desert, California is a residential community where many residents have sought winter accommodation to escape harsh Canadian weather. IDCL did not require the property for business purposes and therefore the expenses related to its maintenance, repairs, taxes and interest are not deductible.

Counsel for the respondent argued that the companies under scrutiny in the case at bar are closely-held companies and, as such, the personal element of the transaction is closely interwoven with the business element. Counsel referred to Justice lacobucci’s decision in Symes v. M.N.R., [1993] 4 S.C.R. 695, [1994] 1 C.T.C. 40, 94 D.T.C. 6001, where reference was made to a vertical and horizontal equity model. Vertical equity, which requires that the incidence of the tax burden be more heavily borne by the rich than by the poor, would prevent deductions taken by the rich which represent personal consumption. The suggestion being that closely- held companies allow wealthier individuals to reduce the taxable income of corporations by deducting personal expenses.

With respect to the determination of whether or not an expense is business or personal, counsel for the respondent quoted the Symes case again to the effect that courts will not only be guided by a taxpayer’s statement ex post facto, but rather, they will look for objective manifestations of purpose.

The respondent argued that with respect to the Palm Desert property, its occupation for personal reasons was for approximately five or five and one half months per year for three and one half years, the total occupation being 18 months. Although the appellants argued that those who visited were there for business purposes, the respondent saw a large personal or social component. According to the respondent, there was no suggestion of income or even of a venture in the nature of trade with respect to the Palm Desert property.

With respect to the apportionment issue, counsel for the respondent referred to Youngman v. The Queen, [1986] 2 C.T.C. 475, 86 D.T.C. 6584 (F.C.T.D.); [1990] 2 C.T.C. 10, 90 D.T.C. 6322 (F.C.A.) in support of the proposition that, when calculating the benefit to a shareholder, the Court should look at the cost to the corporation. Respondent also referred to Soper v. M.N.R., [1987] 2 C.T.C. 2199, 87 D.T.C. 522 (T.C.C.), where it was held that the shareholder benefit should be calculated on the basis of the fair market value rent of the properties made available to the shareholder for the entire year.

Issues

1. Were the expenditures incurred by IDCL as listed in items Al and A3 to A6 of Schedule "A" above, and those incurred by MML listed above, incurred for the purpose of gaining or producing income from a business or property within the meaning of paragraph 18(1 )(a) of the Act?

2. Was the money borrowed and used to acquire the Palm Desert property money used for the purpose of earning income from a business or property within the meaning of subparagraph 20( 1 )(c)(i) of the Act?

3. Were the disallowed expenditures of IDCL and MML personal or living expenses of Barry and Barbara McHugh and did they receive taxable shareholder benefits pursuant to subsection 15(1) of the Act and if so, what was the value of those benefits?

4. Was IDCL entitled to claim capital cost allowance on the Palm Desert property?

5. Was the respondent entitled to make the first reassessment in respect of Barbara and Barry McHugh’s 1981 taxation year under subsection 152(4) of the Act?

6. Are the appellants liable for penalties under subsection 163(2) of the Act?

The relevant sections of the Act are subsections 9(1), 15(1), paragraphs 18(l)(a), 20(1 )(c), section 67, subsections 152(4) and 163(2). During the taxation years in question, these provisions read as follows:

9.(1) Subject to this Part, a taxpayer’s income for a taxation year from business or property is the taxpayer’s profit from that business or property for the year.

15.(1) Where in a taxation year

(a) a payment has been made by a corporation to a shareholder otherwise than pursuant to a bona fide business transaction,

(b) funds or property of a corporation have been appropriated in any manner whatever to, or for the benefit of, a shareholder, or

(c) a benefit or advantage has been conferred on a shareholder by a corporation,

otherwise than

(d) on the reduction of capital, the redemption, cancellation or acquisition by the corporation of shares of its capital stock or the winding-up, discontinuance or reorganization of its business, or otherwise by way of a transaction to which section 88 applies,

(e) by the payment of a dividend or a stock dividend,

(f) by conferring on all holders of common shares of the capital stock of the corporation a right to buy additional common shares thereof, or

(g) by an action described in paragraph 84( 1 )(c. 1 ) or (c.2),

the amount or value thereof shall, except to the extent that it is deemed to be a dividend by section 84, be included in computing the income of the shareholder for the year.

18(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(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;

20(1 )(c) Interest -an amount paid in the year or payable in respect of the year (depending upon the method regularly followed by the taxpayer in computing his income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),

(ii) an amount payable for property acquired for the purpose of gaining or producing income therefrom or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy),

or a reasonable amount in respect thereof, whichever is the lesser;

67. In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances.

152(4) The Minister may at any time assess tax, interest or penalties under this Part or notify in writing any person by whom a return of income for a taxation year has been filed that no tax is payable for the taxation year, and may

(a) at any time, if the taxpayer or person filing the return

(i) has made any misrepresentation that is attributable to neglect, carelessness or wilful default or has committed any fraud in filing the return or in supplying any information under this Act, or

(ii) has filed with the Minister a waiver in prescribed form within four years from the day of mailing of a notice of an original assessment or of a notification that no tax is payable for the taxation year,

(b) within seven years from the day referred to in subparagraph (a)(ii), if

(i) an assessment or reassessment of the tax of the taxpayer was required pursuant to subsection (6) or would have been required if the taxpayer had claimed an amount by filing the prescribed form referred to in that subsection on or before the day referred to therein, or

(11) there 1s reason, as a consequence of the assessment or reassessment of another taxpayer’s tax pursuant to this paragraph or subsection (6), to assess or reassess the taxpayer’s tax for any relevant taxation year, and

(c) within four years from the day referred to in subparagraph (a)(ii), in any other case,

reassess or make additional assessments, or assess tax, interest or penalties under this Part, as the circumstances require, except that a reassessment, an additional assessment or assessment may be made under paragraph (b) after four years from the day referred to in subparagraph (a)(ii) only to the extent that it may reasonably be regarded as relating to the assessment or reassessment referred to in that paragraph.

163(2) Every person who, knowingly, or under circumstances amounting to gross negligence in the carrying out of any duty or obligation imposed by or under this Act, has made or has participated in, assented to or acquiesced in the making of, a false statement or omission in a return, form, certificate, statement or answer (in this section referred to as a "return") filed or made in respect of a taxation year as required by or under this Act or a regulation, is liable to a penalty of

(a) 25 per cent of the amount, if any, by which

(i) the amount, if any, by which

(A) the tax for the year that would be payable by him under this Act

exceeds

(B) the amount that would be deemed by subsection 120(2) to have been paid on account of his tax for the year

if his taxable income for the year were computed by adding to the taxable income reported by him in his return for the year that portion of his understatement of income for the year that is reasonably attributable to the false statement or omission

exceeds

(ii) the amount, if any, by which

(A) the tax for the year that would have been payable by him under this Act

exceeds

(B) the amount that would have been deemed by subsection 120(2) to have been paid on account of his tax for the year

had his tax payable for the year been assessed on the basis of the information provided in his return for the year,

(b) 25 per cent of the amount, if any, by which

(i) the amount that would be deemed by subsection 122.2(1) to be paid for the year by him or, where he is a supporting person of an eligible child of an individual for the year (within the meaning assigned by subsection 122.2(2) and resided with the individual at the end of the year, by that individual, as the case may be, if that amount were calculated by reference to the information provided in the return filed for the year pursuant to that subsection

exceeds

(ii) the amount that is deemed by subsection 122.2(1) to be paid for the year by him or the individual referred to in subparagraph (i), as the case may be,

(c) 25 per cent of the amount, if any, by which

(i) the amount that would be deemed by subsection 127.1(1) to be paid for the year by him if that amount were calculated by reference to the information provided in the return filed for the year pursuant to that subsection

exceeds

(ii) the amount that is deemed by subsection 127.1(1) to be paid for the year by him, and

(d) 25 per cent of the amount, if any, by which

(i) the amount that would be deemed by subsection 127.2(2) to be paid for the year by him if that amount were calculated by reference to the information provided in the return filed for the year pursuant to that subsection

exceeds

(ii) the amount that is deemed by subsection 127.2(2) to be paid for the year by him.

Analysis

It is trite law that a taxable benefit may be conferred on a shareholder by allowing the shareholder the personal use of the corporation’s assets. For example, the corporation may make available to the shareholder for his personal use, a boat, an aircraft, recreational property or any property for no rent or for reduced rent. If this is the case, the shareholder will be deemed to have received a taxable benefit for an amount equal to the prorated operational costs of the property or the difference between the fair market rental value for the use of the property and the rent, if any, charged by the corporation. Different methods have been used to calculate the benefits assessable but the fair rental value, I believe, is the most common. The question is whether the benefit should be calculated on the basis of fair market rental value for the entire period of availability for use or for the period of actual use.

Generally, the benefit to the shareholder is calculated on the basis of his or her use of the property. This rule seems to apply where the property is used and acquired for a business purpose and incidental personal use occurs. If this is the case, then the calculation of the shareholder’s benefit will be based upon actual use. Where the property was not acquired for or used primarily for business purposes, the benefit has in the past been calculated

on the basis of availability for use.

The distinction between property acquired with a business purpose and those not so acquired was made in Houle v. M.N.R., supra, a case referred to by the appellants. The issue was the use by a taxpayer-shareholder, of a yacht owned by a corporation. The shareholder did include in his income for the taxation years in question $1,800 under subsection 15(1) of the Act for the use of the yacht calculated on the basis of the operating costs. Revenue Canada, Taxation argued that the yacht was purchased for personal reasons and, as such, not only should a portion of the operating expenses be added to income as a shareholder benefit but also a percentage of the capital in recognition that if the funds had been used or invested elsewhere, the corporation would have earned a certain rate of return on its money.

The Federal Court-Trial Division did not find that the yacht was acquired for personal use. There was a legitimate business purpose and use of the yacht and, as such, the Minister’s formula would not be applied. The benefit was calculated as submitted by the taxpayer, on the basis of the operating expenses. The Court did not comment on the formula used by Revenue Canada, Taxation.

In the Check et al., supra, decision, the corporation, of which the taxpayer was the principal shareholder, was in the real estate business. The corporation purchased a boat and a boat house for which it claimed deductions in respect of operating expenses and capital cost allowance. The Minister disallowed the deductions claimed by the corporation and assessed the amounts as shareholder benefits. Counsel on behalf of the taxpayer argued that the boat was acquired by the corporation for business purposes and personal use was only incidental. The value of the benefit conferred on the taxpayer should therefore be calculated by apportioning the operating expenses between business use and personal use. Otherwise, the benefit should be calculated on the basis of fair market value rental rates. Bonner J.T.C.C. held that the boat was purchased for business use and the benefit should therefore be computed only on the basis of the eight-hour personal use which was incidental to the business purposes for which the boat was acquired.

The Dudelzak, supra, decision was also referred to by the appellant. The taxpayer in this case lived in a dwelling owned by a company, which he held shares in and was assessed a benefit in respect thereof. The taxpayer did in fact pay rent to the corporation of $1,000 per month. The Minister calculated a benefit in excess of the rent paid and added the difference to the taxpayer’s income. Brulé J.T.C.C. found that the taxpayer did adduce evidence that the dwelling was acquired with a business purpose and on the weight of the evidence, the rent paid by the taxpayer constituted the benefit conferred.

In Youngman v. The Queen, supra, a decision referred to the Court by both counsel, Mr. Youngman conveyed land to a corporation for development. The corporation was unable to develop the land although several attempts were made. Eleven years later, a luxurious home was built on the land for Mr. Youngman and his family who moved in and only paid $1,100 monthly, $300 of which was for utilities. The Minister assessed on the basis that a benefit was received and the Court agreed. With respect to whether it was a bona fide business transaction, Justice McNair of the Federal Court-Trial Division made the following comment (C.T.C. 480, D.T.C. 6588):

Clearly, the countervailing factors of business purpose or personal use must play a significant role in determining as a question of fact whether the particular corporate transaction is a bona fide business transaction in the sense of something that might normally accrue to an outsider in the ordinary course of business of the corporation or whether it was an inside arrangement designed primarily to benefit a shareholder.

The Court found that taking everything into account there was no cogent or compelling evidence of a bona fide business transaction and the house was simply intended for the personal use of the Youngmans right from the start. As for the calculation of the benefit, the Court disregarded the fair rental value of the property and held that the shareholder benefit was equal to the capital cost of the home computed on the basis of a 9 per cent rate of return on the corporation’s equity with certain adjustments. The Federal Court of Appeal agreed. What was saved by the Youngmans was the capital cost of acquiring their dwelling.

This case departs from the traditional view of measuring the benefit in terms of fair rental value. The case also ignores the fact that the property is still owned by the corporation. The Youngmans only had a right to exclusive possession of the property and not proprietary rights as would suggest the amount of the benefit imputed to the shareholder.

In Soper v. M.N.R., supra, the Minister assessed the taxpayer for an amount equal to a full year’s rental of houses in Florida made available to her throughout the entire year, although they were only used by her for one month per year. The taxpayer agreed that a benefit may have been conferred but that value of the benefit should be calculated on the basis of her actual use of the property. Rip J.T.C.C. agreed with the Minister’s assessment. The properties purchased by the company, Manor, were not used as part of the business. They were acquired with the intention of resale at a profit and for the pleasure of the controlling shareholder, Mrs. Soper. They were only used by the shareholder and her family for personal reasons. Judge Rip states:

In considering Mrs. Sober’s submissions one must ask who was benefiting from the properties when they were not being used by Mrs. Soper. Manor was receiving no income from the properties but was paying all the expenses: surely Manor gained no benefit.

This case is therefore distinguishable from the one at bar. The McHughs used the property in question for personal reasons yet a business purpose and use was present. In contrast to the Soper decision, is the Giffin et al. v. M.N.R., supra, case, referred to by the appellants, where a corporation purchased a residence in Florida which was frequently used by the principal shareholder, only the rental value computed with reference to actual days of use was added to the income of the shareholder. The case is interesting because Judge Margeson did find that the property was acquired with the intention that it be used both personally and for business purposes.

In the case at bar, with respect to the Palm Desert property, I believe the property was acquired, and in fact used for business purposes. However, there was also a personal benefit conferred on the shareholders, the McHughs, by IDCL in allowing them the use of the property for other than business use. I am satisfied that the value of the personal benefit so conferred was not as great as argued by the Minister. I would conclude that a benefit was received by the shareholders, the McHughs, equal to the fair market rental value of the property during the period of actual personal use. Counsel for the appellants acknowledged that the use of the condominium may be considered to have an element of personal use and benefit. The parties agreed to a per month amount for a standby charge based on the cost of the property. For the relevant taxation years the amounts agreed upon by the respondent and those agreed to by the appellants are as follows:

The property was actually used by the individual taxpayers for five months of the years 1982, and 1983 and it was sold in January 1984. The fair market value has been agreed upon with the exception of the maintenance and repair expenses. Following the reasoning in the cases cited by the appellants, namely Houle, Giffin, Check et al. and Dudelzak, the shareholder benefit is to be computed on the basis of actual use, the subject property having been acquired for business as well as personal purposes. I find that the property was used for personal reasons three months of each year and the total benefit attributable to the individual taxpayers should be calculated using the appellants’ figures for the per month fair market rental value. As the property was sold in January 1984, I will not assess a shareholder benefit regarding that year.

With respect to other expenses, I agree with the appellants’ argument that because they were not deductible by the company does not necessarily mean that the appellants Barry and Barbara McHugh were benefiting within the meaning of section 15 of the Act. While Nevada EDC expenses are not deductible by IDCL, it does not mean that Mr. McHugh benefited by working for months in the Nevada desert.

Dealing first with what has been described as the "IDCL business expenses" in the notices of appeal filed on behalf of the McHughs, and listed in the Schedules "B" and "C" above at item 1(a). These expenses are the expenses incurred in maintaining the Palm Desert property, the meals, transportation and client entertainment expenses incurred by IDCL and the expenses paid by IDCL in lieu of rent. I have decided that a fair and reasonable approach would be to assess a shareholder benefit for 60 per cent of those expenses which have not been already settled, less of course any income reported regarding the use of those assets. The same conclusion is reached regarding the expenses paid by MML. 60 per cent of those expenses not yet settled are to be assessed as a shareholder benefit.

The next issue with respect to the individual appellants is whether the reassessment of their 1981 taxation year was within four years after the day mentioned in subparagraph 152(4)(a)(ii) of the Act. The respondent initially assessed Barbara McHugh’s 1981 taxation year for the first time by notice of assessment dated July 15, 1982. By notice of reassessment dated June 22, 1987 the respondent reassessed the appellant Barbara MCHugh in respect of her 1981 taxation year. The respondent pleaded that the individual appellants had waived their rights pursuant to subparagraph 152(4)(a)(ii) of the Act. The appellants did not actively pursue their submission. Considering the respondent’s evidence with respect to this issue, I find there was a basis for the respondent to make a reassessment for the 1981 taxation year.

Dealing now with the appeal filed on behalf of IDCL, taken from the Schedule "A" above, the expenses claimed by the appellant and disallowed by the respondent for travel and promotion were $43,608 in 1981, $38,445.93 in 1982, $41,930.37 in 1983 and $47,792.94 in 1984. Evidence of these disallowed expenditures was provided by way of credit card records and other vouchers. Expense analysis ledger pages for IDCL were produced in evidence including hundreds of entries attempting to detail expenditures.

The appellants have the burden of proving that the respondent’s assessments are wrong and establishing that the corporate expenditures were made for the purpose of gaining income. Counsel for the appellants submitted that the expenses fall into four categories:

A. Canadian travel;

B. Canadian promotion, including a weekly business lunch;

C. U.S. travel and food other than Nevada; and

D. Nevada expenditures.

The income-producing wells of IDCL, which produced basically all of the income for all four appellants, were in northern Alberta. It is reasonable to conclude that travel and promotion expenses, in the area of these wells, are deductible. As a generalization, without the benefit of specifically allocated amounts, the money expended in the first two of the appellants’ categories, are reasonable business expenditures and permitted deductions.

The bulk of the travel and promotion expenditures referred to, fall into the remaining two categories namely, U.S. travel and food other than in Nevada and Nevada expenditures.

Counsel for the appellants urged the Court to keep in mind the position that IDCL’s financial success is evidence of Mr. McHugh’s proven respectable business judgement. Counsel quoted a passage from ELB Productions v. M.N.R., [1991] 2 C.T.C. 2661, 91 D.T.C. 1466 (T.C.C.), which reads in part at page 2663 (D.T.C. 1468):

...it is not the place of this Court or of the Minister of National Revenue, after the event, to second-guess a taxpayer’s business acumen.

The appellant submitted that he was constantly pursuing expansion and diversification of the existing business and virtually all his expenditures were incurred for the purpose of gaining income. Referring to IDCL’s travel expenses, counsel stated the following:

In the 1981 taxation year, the corporation had gross revenue of $686,500. The amount that was claimed by the taxpayer was $44,608. That represented 6.5 per cent of total gross revenue. The other numbers come out of the financial statements which are before the Court, gross revenue increased in the next year. The percentages being in 1982 the amount claimed represented 6.1 per cent of gross revenue. In 1983, it represented 9.1 per cent. And in 1984 it represented 11.9 per cent.

Counsel for the respondent quoted from Iacobucci J. in Symes, supra, at page 736 C.T.C. 58, D.T.C. 6014), which reads in part:

...no test has been proposed which improves upon or which substantially modifies a test derived directly from the language of paragraph 18(l)(a)....

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. For these reasons, it is not possible to set forth a fixed list of circumstances which will tend to prove objectively an income gaining or producing purpose.

Barry McHugh had the U.S. corporation EDC incorporated primarily to carry on the Nevada undertakings. IDCL loaned the U.S. corporation operating funds. IDCL was to benefit through a participation agreement between IDCL and EDC. EDC was not successful and the loans were not repaid. There is no allocation or breakdown of the travel and promotion expenditures by IDCL relating to the Nevada project. These expenditures for the benefit of the Nevada project, while they may well be deductible by EDC, are not deductible expenses of IDCL. It is not necessary that the expenditure should have resulted in income but had EDC generated income it would have been income in the hands of that U.S. corporation. Any partic Ration of IDCL is too remote to entitle it to a deduction for EDC expenses. There was no clear and persuasive evidence that these expenses, incurred by IDCL for the pursuits of EDC in the Nevada desert, were sufficiently related to the income earning activities of IDCL.

With respect to the Palm Desert property, the appellants submitted that the condominium was IDCL’s U.S. presence and that it was acquired in pursuit of IDCL’s business activities. It is interesting to note that as Taylor J.T.C.C. put it in Inland Development Ltd. v. M.N.R., [1989] 1 C.T.C. 2141, 89 D.T.C. 95 (T.C.C.), where the same taxpayer sought to declare an aircraft as a business expense, that there may be appropriate company business expenses that are not acceptable as income tax business expenses, the latter being of a higher standard. What the taxpayer considers a legitimate business expense may not be sufficiently connected to the generation of taxable income to constitute an income tax deduction.

There was very little documentation and corroboration to support the contention that all the western U.S. activities and expenditures were business related with the notable exception of the EDC Nevada project. The Palm Desert property was a comfortable winter home for Mr. and Mrs. McHugh during five months of the year. Yet, having reviewed all of the evidence, I conclude that it was acquired primarily for the business use of the appellants, with a secondary personal component.

With respect to the expenditures titled travel and promotion, in reviewing the jurisprudence presented by both counsel, one can find an extreme position and a generous position. The first being where Courts insist on an immediate and direct connection of expense to income. The second of course, is the other extreme. Both counsel acknowledged that a reasonable approach may be to allocate in a fair manner a percentage as a deductible business expense and a percentage as personal benefit.

There must be a definite link between the expenditure and the income gain with regard to the U.S. expenditures for food, accommodation and travel. We do not have a specific breakdown. The Court is left to speculate or guess which expenditure is with respect to what specific business pursuit. The major U.S. business venture was Mr. McHugh’s work towards establishing a pipeline from western Canada into the southwestern U.S. This project could be described as a fixation of his. It did not come to fruition which in itself is not fatal to the deductibility of expenditures. Much of the U.S. expenditures were made in pursuit of the pipeline venture and the Nevada project. The appellants argued that one cannot discount or second-guess the feasibility of the pipeline. Given Mr. McHugh’s business success and acumen, it cannot be classified as a dream or a hobby. Counsel presented that hours, days and months were spent in southern California on the pipeline project. While this may be so, the evidence presented with respect to the expenditures was a general demonstration that IDCL expended money for meals at restaurants and transportation in western U.S. but there was little tangible or direct link between the expenditure and the business purpose. The direct connection between the two in most instances was vague.

Mr. McHugh’s pipeline project efforts appear to have commenced in the late 70s and have continued into the 19903. The evidence would lead the Court to conclude that this venture was not a realistic economic endeavour. The likelihood of Mr. McHugh’s pipeline passion becoming a reality in the immediate future or within a reasonable time from the relevant years at issue was remote. The direct link between expenditure and gaining income was not present. It is possible that those start-up expenditures could be a capital outlay, should the pipeline venture proceed. It is not necessary for the venture to succeed and produce income; see M.N.R. v. M.P. Drilling Ltd., [1976] C.T.C. 58, 76 D.T.C. 6028 (F.C.A.) and Tobias v. The Queen, [1978] C.T.C. 113, 78 D.T.C. 6028 (F.C.T.D.), but there must be a more direct or immediate link between the expenditure and the gaining of income from business than is present in this case.

For the same reasoning, the expenditures for the Hawaiian jojoba bean trips do not qualify. There must be a more immediate connection between the expense and income than what was presented.

There was the evidence of Barry McHugh corroborated by Barbara McHugh to the effect that the Palm Desert property was used for business purposes. A small office was reserved for business purposes, there was a liaison with the Calgary office and business guests were entertained. The Court is satisfied, from all of the evidence, that some of the expenses claimed meet the criteria set in paragraph 18(l)(a) and in jurisprudence. Common sense would dictate that some expenses meet the deductibility criteria and an attempt should be made to arrive at a fair and reasonable allocation.

In the end result, I am satisfied that there was an allowable business component with regard to the expenditures incurred by the appellant IDCL during the relevant period within the meaning of paragraph 18(1)(a) of the Act but not to the extent claimed by the appellant. Of the expenses disallowed for travel and promotion, 35 per cent was incurred for business purpose and therefore permitted as a deduction under paragraph 18( l)(a) of the Act. Regarding the interest expense on the Palm Desert property, I find that 30 per cent of the money borrowed was used for the purpose of earning income from a business or property within the meaning of subparagraph 20(l)(c)(i) of the Act. That proportion of the interest expense is therefore allowed as a deduction under the aforementioned provision of the Act.

Concerning the repairs and maintenance expenses disallowed on the Palm Desert property and on the Calgary house, the primary purpose of those expenses was also personal. Once again I allow 30 per cent as the percentage of the amounts still in issue to be allowed as a deduction. The same percentage of the amounts in issue regarding the property taxes on the Palm Desert property and the dues and subscription expenses are to be allowed. The telephone and utilities expenses and the trailer expense have been settled and I will not deal with those issues. No deduction is to be allowed for the vehicle expense in Palm Desert. The appellant IDCL is denied a deduction for capital cost allowance on the Palm Desert property and furniture related thereto.

As for the expenses incurred by MML and which have not been settled by the parties, I allow 40 per cent of the amounts still in issue as a deductible business expense.

The final issue is with respect to penalties under subsection 163(2). The respondent has the onus of establishing that the appellants knowingly or under circumstances amounting to gross negligence understated income through the claiming of deductions. Counsel for the appellant quoted Strayer J. in Venne v. The Queen, [1984] C.T.C. 223, 84 D.T.C. 6247 (F.C.T.D.), at page 234 (D.T.C. 6526):

"Gross negligence" must be taken to involve greater neglect than simply a failure to use reasonable care. It must involve a high degree of negligence tantamount to intentional acting, an indifference as to whether the law is complied with or not. I do not find that high degree of negligence in connection with the misstatements of business income.

This reasoning and definition are generally accepted in the considerable jurisprudence dealing with the definition of gross negligence as contained in subsection 163(2) of the Act. I agree with the appellant’s counsel that "a high degree of negligence tantamount to intentional acting" did not exist in the present case. The respondent has not met the burden of proof required. I find there is no gross negligence and accordingly penalties are not properly exigible under subsection 163(2) of the Act for the taxation years 1982, 1983 and 1984.

Appeals allowed.