Dr. Valcav Hyrman v. Her Majesty the Queen, [1995] 1 CTC 2772, 95 DTC 550

Rip J.T.C.C.:—The issue in these income tax appeals is whether certain scientific research and experimental development expenses were incurred by Dr. Valcav Hyrman or Cheakamus Holdings Ltd. ("Cheakamus") and Electro Medical Technology Corp. ("EMT"). The Minister of National Revenue ("Minister") reassessed Hyrman for 1987, 1988 and 1989 by disallowing deductions the appellant made in computing income from his medical practice on the basis the amounts deducted were shareholders loans to Cheakamus and EMT and not research and development expenses. In reassessing 1988, the Minister also disallowed a claim of $13,000 on the "basis that no cheques supported the advance or payment of the $13,000".

The Minister also disallowed certain rental property expenses for 1988 and 1989 and assessed penalties for 1987, 1988 and 1989 pursuant to subsection 163(2) of the Income Tax Act, R.S.C. 1985 (5th Supp.), c. 1 (the "Act"). The appellant abandoned his appeals with respect to his claim for the rental expenses and counsel for the respondent advised that the Minister waived the assessments of the penalties since there was no evidence to support them. I agree that there was no evidence to support either the rental expenses or the penalties.

Hyrman left Hungary after the revolution there and after living two years in Sweden immigrated to Canada in 1971. He obtained a medical degree in Hungary, specializing in psychiatry, in 1968. He qualified to practice in British Columbia in 1979; earlier he qualified to practice in New Brunswick. During his first years in Canada he worked in hospitals but at time of trial he limited his practice to private patients. Hyrman had no other business or accounting training or experience.

In 1981 Hyrman was involved in an aborted real estate venture with other investors. Cheakamus was incorporated for the venture and because he paid the incorporation fee, Hyrman kept the corporation. He owned the one issued share in Cheakamus.

Hyrman invented an electro convulsive therapy instrument to create seizures in patients with memory impairment and brain damage; apparently seizures may terminate periods of psychosis or depression. The instrument, called "Compect", combined a pulse generator, a computer and software that sends out the stimulus. Similar instruments had been used by the profession since 1938. Modifications were made to the machine over the years and Hyrman first used the machine in 1991. The machine was in the development stage during the years in appeal. Most of the research was performed on the software: different programs were tried and different computer languages were applied.

At first Hyrman thought he could finance his efforts with his own funds. When he realized he required more capital than he could afford he applied for funding to the National Research Council of Canada ("NRC"). A grant officer at the NRC Industrial Research Assistance Program informed him grants were awarded through a university or a corporation. Hyrman was working at the Royal Columbia Hospital in Vancouver at the time and could have funnelled a grant through the University of British Columbia. However the university would "skim off 15 per cent" of the grants and he thought it would be easier to use his dormant company, Cheakamus, to accept the grant and did so.

Hyrman sought technical assistance to develop "Compect" from Jiri Cernik, an electrical engineer. Cernik volunteered to help develop the project and built a machine which Hyrman used in a hospital. In 1986 or so, Cernik secured a portion with an international telecommunications company and lost interest in the project, said Hyrman. Hyrman testified he and Cernik had agreed that he would own 51 per cent of Cheakamus and Cernik 49 per cent. No shares were issued.

In the middle of 1986 Hyrman hired another electrical engineer, Jan Beran. Beran had organizational and managerial skills, according to Hyrman. Cernik agreed with Hyrman that he, Cernik, "would give" Beran one-half of his shares in Cheakamus so that each would own 24-1/2 per cent of the shares. The arrangement was verbal. No shares were issued to Beran and no money changed hands. Hyrman stated that if the "Compect" project made money, Cernik and Beran would be entitled to a share of the profits under an arrangement that would be "work[ed] out later". Cernik and Beran devoted their time to design and development and Hyrman to clinical work. Research was related to the design and development of "Compect" and the building of prototypes. A "Compect" type machine was in use at the Riverview Hospital in Vancouver and two machines were sold and two were loaned to hospitals in Czechoslovakia. At time of trial, Compect was in the marketing stage. Hyrman considered Cernik and Beran partners in the project but not shareholders of either corporation, although all three are identified as shareholders in tax returns of both Cheakamus and EMT. Beran considered himself a shareholder of EMT and had a verbal agreement with respect to Cheakamus.

Hyrman applied to the United States Patent Office on March 11, 1985 for a patent of the electro convulsive therapy method and the Patent Office granted him a patent on December 1, 1987. Hyrman transferred a 20 per cent interest in the patent to his former wife in 1988 as part of a property settlement.

In his first year in Canada Hyrman had his tax return prepared by a tax preparation service. Since then he prepared his returns himself. He maintained his accounts on a computer spread sheet; he also had a manual entry payroll book.

From 1983 to 1986 most of the money to develop the machine came from Hyrman, but Cheakamus did receive some government grants.

Hyrman included two statements of "professional" income and expenses (Form 72032) in his 1983 income tax return. One form was in the name of Valcav Hyrman and the firm name was Cheakamus Holdings Ltd. The principal service of the profession was "scientific research". No income was reported but $15,653.92 of expenses were claimed. In the other statement of "professional" income and expenses Hyrman included income from his medical practice. Among the amounts deducted in computing income from his practice was the $15,653.92 claimed as a scientific research expense. He continued to include two statements of "professional" income and expenses in each of his 1984, 1985 and 1986 tax returns, one statement to reflect income and expenses from scientific research in the name of Cheakamus, the other to reflect income and expenses from his medical practice. The grants from NRC were the source of income to Cheakamus. Hyrman claimed the excess of expenses incurred in Cheakamus’ name over income from grants as an expense in the statement of income and expenses for his medical practice.

In reply to a question put to him by his lawyer, Hyrman stated he included Cheakamus receipts and expenses in his personal tax return because "the tax forms and tax guide asked for each separate business and so I put both in...[I] didn’t separate [my] practice from research for tax purposes".

Hyrman included only one statement of income and expenses in his 1987, 1988 and 1989 tax returns, the statement for his medical practice. The 1987 statement includes in income, grants of $40,600 received by Cheakamus and in expenses, $78,822.80 Hyrman paid to Cheakamus for research. In his 1988 and 1989 returns Hyrman reported no income from scientific research as a separate item in the statements of income and expenses from his practice. However he deducted expenses for "research Cheakamus and EMT" in computing income from his profession for 1988 and 1989. These were expenses the Minister says were incurred by Cheakamus and EMT.

In 1987 Hyrman applied for a grant under the Industrial and Regional Development Program, Western Economic Diversification ("IRDP"). The grant, Hyrman explained, was based on expenditures by the recipient and so Cheakamus started paying Hyrman a salary "to put value on my work as a company contribution to...[the] project". Other salaries were paid to others as well so as to put a value on the company’s contributions. He said the officials at the IRDP insisted on proof of payment by cheque. Cheakamus had no money to pay a salary and so "I had to put money into the company to pay myself.... To my knowledge Western Diversification wanted guarantees we have money...wanted list of investors...but we operated without (other) investors...." Hyrman testified he made a "rough estimate" of his income working full-time as a psychiatrist and "deducted the two days a week for the company" to determine the amounts Cheakamus and EMT were to pay him.

Hyrman testified that Cheakamus did not file tax returns for taxation years 1983 to 1986 inclusive.

Copies of cost claim summaries, operating costs and other documents Cheakamus submitted to IRDP were produced at trial. The calculations on the documents were not in Hyrman’s handwriting but he signed the claim summaries on behalf of Cheakamus. He assumed the documents were prepared by Beran. Hyrman testified that the first grants were based on money spent on the project but later grants related to investments in the project and that is the reason he loaned money to the companies. A "huge” portion of the research expenditure represented labour costs.

Financial statements and tax returns of Cheakamus were prepared the first time for its 1987 fiscal year. The returns were prepared by a firm of chartered accountants, Tierney & White, who had prepared unaudited financial statements for 1987. Apparently Beran had suggested the company start using the services of an accountant. This was the first year salaries were paid. Cheakamus made its first claim for scientific research and tax credits in 1987; Revenue Canada rejected the claim for 1987. The original balance sheet for 1987 showed that the company had shareholders loans of $58,980, the bulk owed to Hyrman. The tax returns and balance sheet were amended in 1992, amongst other things, to correct the recording of contributions to the company received from the shareholders. A note to the amended statements informed the reader "contributions now showed as a recovery of expenses on the statement of deferred development expenditures". An amount of $107,275 was shown as the recovery of expenses. The statements also included a statement of deferred development expenditures of Cheakamus for the year. Cheakamus claimed depreciation on its assets.

The 1988 and 1989 tax returns for Cheakamus were prepared in substantially the same manner as those for 1987. Cheakamus included grants it received in its income for these years. Cheakamus applied for an investment tax credit in its income tax returns for 1988 and 1989 and received most of the credits it claimed. EMT filed its returns for 1988 and 1989 in the same manner as Cheakamus. In 1989, EMT’s scientific research and development expenditures first exceeded those of Cheakamus. All the financial statements and tax returns were prepared by Tierney & White. Mr. Phillip White C.A. was the partner in charge of the files.

Hyrman had met White on one occasion before 1991 "when Revenue Canada got involved". Beran and Bronco Hyrman, the appellant’s brother, were in contact with White. Essentially the amended returns changed the treatment of shareholders loans to expense recovery. Hyrman said he signed tax returns-I assume the original and amended returns-without discussing their contents with White. Beran said White never asked about the shareholders’ loans when he prepared the amended returns. White confirmed he "never determined the appropriateness of the designation" and he never offered any advice.

Hyrman testified he first became aware in 1988 or 1989 the corporations applied for investment tax credits when Beran so informed him. Hyrman at the time "understood it was nice of the government to support scientific research...! was delighted". The appellant said he did not understand how the credits related to his personal tax return.

Respondent’s counsel asked Hyrman if he was aware a tax credit was refunded to a corporation at a higher rate than that of an individual. Appellant replied he "did not realize this".

Hyrman explained that his brother Bronco, who immigrated to Canada around 1987, helped set up his accounting system with the help of a software program. Bronco Hyrman had no accounting experience.

Hyrman and his wife separated in 1986. He said that his wife wanted one-half of Cheakamus. He commented that there was "no way I could imagine operating a company with her" and told her she could have all of the company and he would incorporate a new company, which he did. Beran formed EMT "without lawyers". He did not transfer Cheakamus to his wife but curtailed its operations and started to carry on research in EMT. The shareholdings of EMT were to be the same as in Cheakamus but no shares were issued. No steps were taken to transfer ownership of the patent from Hyrman to EMT. During the first year of EMT’s existence Cheakamus and EMT worked on the "Compect" project together, said Hyrman, since Cheakamus was working on a previous grant. Hyrman thought that additional investors would participate in EMT "and Cheakamus would get out". No additional investors were found.

Beran left Canada about two years ago, according to Hyrman, and gave up his shares. "He was not paid anything". However, he appeared as a witness at trial.

Hyrman estimated he spent about 20 per cent to 40 per cent of his time on the "Compect" project. He was in charge of the project. To "reflect my involvement" he had Cheakamus and EMT give him cheques for varying amounts. But, in his view, he "never received money because I had to put it back.... Always, with the exception of one year, I put in more [than I took out]". For example, in 1987 Cheakamus paid him a salary of $40,000 and he advanced the company $78,827. Hyrman said that to take money out of the company, he had to put money in the company. The money he took out was included in income for tax purposes; however because the Minister considers the moneys he paid to each company as loans, he is unable to deduct the amounts so advanced in computing his income. The appellant cannot understand the reason "why [I’m] taxed on money not made”.

The appellant took the position that the description of the amounts on the balance sheets of Cheakamus and EMT as shareholders loans is wrong. The software program used by Bronco Hyrman had an entry entitled "shareholders loans" and Hyrman said "Bronco thought it would be a good way to keep track of the money" advanced to the companies. Hyrman acknowledged he "was aware it was called shareholder loans.... I thought it was a clever idea of Bronco to keep track...[I had] no understanding of the consequences". He said he had "no reason to believe anything was incor- rect". Only when the companies "were audited by Revenue Canada did [he] realize the expenses [were] to be disallowed". Beran said the term "shareholders loans" was used to show money was going into the company and he wanted these advances to be reflected in the company’s books.

Money was advanced to Cheakamus and EMT by cheque. "Bronco also loaned a little money to the company...[which]...was recorded as a shareholder loan even though he was not a shareholder." The advances by Hyrman and Cernik were "dependent on who had money", said Hyrman, and not on their purported shareholdings in either company. Beran testified he loaned money to EMT because, as a shareholder, he wanted it to succeed.

White testified that he was retained "basically, to prepare tax returns" and the financial statements he prepared for Cheakamus and EMT were "the lowest level of review". White agreed he was retained by Beran "to prepare the tax returns for the scientific tax credit". He added he had "no idea of Hyrman’s personal tax return or (the) basis of the return".

Respondent’s counsel wondered if Hyrman ever asked the reason he was filing tax returns for Cheakamus for 1987 when he did not file before. Hyrman replied "[I] thought...because of tax credits...." He did not query White the reason tax returns were filed in the later years.

Hyrman stated he "had quite a conference with the accountant" when the amended returns were filed. At the time these returns were filed he thought Beran was a shareholder of Cheakamus. He also acknowledged that Cheakamus withheld statutory amounts on salary it paid his brother.

Once Cheakamus filed its tax returns, Hyrman ceased to report its income and expenses in his return. He realized a new system of reporting income had started.

No formal meetings of directors of either corporation took place, although copies of unsigned minutes of general annual meetings of the sole shareholder of Cheakamus are included among the appellant’s exhibits. The minute book of EMT contains only the corporation’s incorporating documents and copies of provincial annual reports for 1989 and 1990.

During the same week that I heard this appeal I heard the appeal of 1462 Investments Ltd. v. Canada, [1995] 1 C.T.C. 2545. The issue in 7462 Investments was whether a corporation carried on a business as trustee or on its own account. Here, too, the issue is whether business activity was carried on by a corporation for its own benefit or for the benefit of others or in a joint venture with others, as argued by Hyrman’s counsel. Many of the same cases were cited by counsel in both appeals. In 1462 Investments I referred to five questions posed for answer by Meredith J.A. in McKinnon v. Harris, [1909] 14 O.W.R. 876, 1 O.W.N. 101 (C.A.), at page 878 (O.W.N. 102), cited by Cattanach J. in Bouchard v. The Queen, [1983] C.T.C. 173, 83 D.T.C. 5193 (F.C.T.D.), at page 183 (D.T.C. 5202):

1. is the claim supported by probability?

2. is it supported by writing in any form?

3. is it supported by any indisputable facts?

4. is it supported by disinterested testimony?

5. is the parol evidence quite satisfactory and convincing?

These questions are not intended to be all exclusive.

On the facts of this appeal, as in that of 1462 Investments, the answers to these questions are found in the answer to the question: whose business or research was really being carried on? That is really the question I am being asked to decide. It is a question of fact whether Cheakamus and EMT were carrying on the business or research for Hyrman, for themselves or in a joint venture. In Smith, Stone and Knight Ltd. v. City of Birmingham, [1939] 4 All E.R. 116 (K.B.) at 121, Atkinson J. found six points he deemed relevant for the determination of the question: Who was really carrying on the business?

In all the cases, the question was whether the company, an English company here, could be taxed in respect of all the profits made by some other company, a subsidiary company, being carried on elsewhere. The first point was: Were the profits treated as the profits of the company?—when I say "the company" I mean the parent company-secondly, were the persons conducting the business appointed by the parent company? Thirdly was the company the head and the brain of the trading venture? Fourthly, did the company govern the adventure, decide what should be done and what capital should be embarked on the venture? Fifthly, did the company make the profits by its skill and direction? Sixthly, was the company in effectual and constant control?

Counsel for Hyrman led evidence that in the case of Cheakamus only one share had been issued and in the case of EMT no shares were issued. Neither corporation had meetings of directors or shareholders, although minutes of annual meetings of shareholders of Cheakamus had been prepared but were not signed.

Hyrman treated Cheakamus as his agent before 1987. Cheakamus did not file tax returns. Hyrman prepared a statement of "professional" income and expenses for the work carried on in the name of Cheakamus but clearly identified the statement in his personal tax returns and his income and expenses. After 1986 all this changed and Hyrman treated first Cheakamus and then EMT as corporations carrying on research activities on their own accounts. There is no independent evidence that either carried on the research in a joint venture with Hyrman or as his agent or trustee. The corporations represented to organizations awarding grants and to Revenue Canada that they were the persons actually carrying on scientific research and development and the organizations and Revenue Canada acted on these representations. Hyrman’s tax return for the years in appeal and the companies’ tax returns were prepared on the basis that the respective companies carried on the research and development. The books and records of Cheakamus and EMT reflected this state of affairs as well. According to Hyrman the only way to obtain certain grants was for the corporations to pay salaries to prove the companies’ "investment” in the research carried on. He then lent the salary back to the corporations. Grantors also required a degree of investment in the receiving corporation. The appellant cannot have it two ways: that it was he who carried on the research for his own personal tax purposes but it was Cheakamus and EMT who carried on the research for purposes of obtaining grants and tax credits.

The losses were treated as losses of either company in their financial statements. The companies had employees. All decisions were corporate decisions. The particular corporation filed grant applications on its own behalf and carried on research with the skill provided by its employees. Each corporation was in effectual and constant control of the research and development. It is true that Hyrman had obtained the U.S. patent for the process but it is also true that after 1986, the process for which he had received the patent was subject to ongoing development by the two corporations.

There were no circumstances where either Cheakamus or EMT so conducted themselves in the years in appeal that it would be inequitable to allow them to deny to Hyrman the scientific research and experimental development expenses. There were no words or conduct by either corporation that one may reasonably conclude may have induced Hyrman to act to his own detriment in the reasonable belief that in so acting he could be said to personally carry on the development of "Compect”: Gissing v. Gissing, [1971] A.C. 886, [1970] 2 All E.R. 780 (H.L.), at page 905 (All E.R. 790), per Lord Diplock, cited in De Pol v. Cunningham, 49 T.C. 445 (C.A., Northern Ireland) by Jones L.J. at page 467. In fact all of the representations to third parties in documents executed by Hyrman on behalf of Cheakamus and EMT were to the effect that it was the particular corporation that was carrying on the scientific research and development. The tax credits claimed were on the basis of corporate, not individual, rates. The agencies providing grants did so on the basis of activity within each corporation. There were no representations either corporation acted as agent, trustee, "prête-nom” or nominee of Hyrman or was in a joint venture with Hyrman. For these reasons the answers to each of the five questions posed by Meredith J. must be "no". There was no trust. Cheakamus and EMT carried on the research in the years in appeal on their own accord.

The salaries paid Hyman by the two corporations were made freely to satisfy the requirements of IRDP that Cheakamus and EMT incur expenditures in the course of carrying on research and were received by Hyman without any objection by him. The initial grants from IRDP were related to these expenditures. Hyman returned his salary to the respective corporations in the form of loans so that they again would be eligible for grants. I cannot find any authority that Hyman not be taxed on the salary he received in these circumstances.

This is an unfortunate situation. Companies were incorporated, business was carried on, grants were requested and received and money was con- tinuously being transferred between Hyrman and the corporations. All of this was done without any legal or accounting guidance and the results for the appellant are disastrous.

I advised counsel I would delay preparing judgment until December 5, 1994. In the meantime the parties were to take the opportunity to review the evidence and other material that for some reason or other was not before me and attempt to resolve this matter. I was advised by counsel for the respondent the issue is still in dispute.

The appeals are allowed only to the extent that the penalties assessed be deleted. The respondent shall have her costs.

Appeals allowed.