Andrew Potulicki v. Her Majesty the Queen, [1993] 1 CTC 417, 93 DTC 5196

Joyal, J.:—

Background

This is an appeal by the taxpayer from a tax assessment for the years 1984 and 1985 where the respondent disallowed certain business expenses claimed by the appellant in connection with a business named Rainbow Colour Printing Plate Services. The grounds for disallowance were that the plaintiff's business did not have a reasonable expectation of profit. The disallowed claims were in the amounts of $5,976.16 for the year 1984 and $5,201.24 for the year 1985.

The appellant, from all appearances, is a stable, hardworking individual enjoying the usual attributes of care, thrift and thoroughness, who had been involved for many years in the operation of a small pre-print shop in Welland, Ontario. This operation, over several years, enjoyed only marginal returns. The evidence discloses that in 1982, the business generated $5,300 of income and suffered a loss of $10,600. In 1983, gross income fell to $1,077 and the loss amounted to $7,900. Furthermore, in the years 1984, 1985 and 1986, the business was not operated at all, but the carrying charges and other recurring expenses on the premises resulted in total losses for these years in excess of $14,700.

Appellant's position

The position taken by the plaintiff is that throughout the years in question, it was his ambition to turn his shop into a profitable one. He had deliberately maintained his shop as a sort of going concern, hoping all the while that his financial stability and the market opportunities would enable him to reactivate it in the short term. The appellant, in the meantime, relied on his relatively good employment income in Toronto to pay the shop's recurring expenses and to provide him with a living.

According to the perception of things declared by the appellant, his ambitions, his outlook and his plans were all of a nature to justify his charging off these losses against his employment income. He sees no difference between his situation and that of any other taxpayer whose business is interrupted by a fire at a plant or who suffers a stoppage of work by reason of labour problems. Basically, it is the appellant’s view that his business, through the years 1984 and 1985, had a reasonable expectation of profit and that the losses he suffered should be deductible.

In a ten-page brief submitted to the Court, the appellant sets out the substantive grounds for his attack on the assessments. Where, he says, the definition of “living and personal expenses" found in section 248 of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"), treats these expenses as having been incurred for the use of or benefit to a taxpayer, it should exclude those expenses incurred in connection with a business carried out for profit or with a reasonable expectation of profit. The thrust of that provision, says the appellant, is to curtail tax evasion by engaging in a sideline business which, as an essential part, brings to a taxpayer "side benefits" while at the same time producing monetary losses.

The appellant then asserts that "a secondary benefit element to a taxpayer must be proven to exist as a condition sine qua non if a business is to be deemed an operation having no reasonable expectation of profit and its expenses deemed to be personal or living expenses". Surely, says the appellant, it cannot be argued that the costs he incurred in maintaining the lease on his shop and in keeping intact the equipment therein resulted in any secondary benefits to him.

The appellant then concludes that his situation is akin to Canadian Armed Forces defence hardware being put in mothballs in times of peace, pending future crises, or a gold mine stopping production until the price of gold goes up. In the latter case, especially, the expenses of maintenance would be considered deductible as being spent in the pursuit of ultimate profit. The small entrepreneur, says the appellant taxpayer, should be in a position to claim a similar tax deduction.

Respondent's position:

The respondent takes a somewhat more hardline position. The respondent reviews the profitability of the appellant’s printing operations, not only in the 1984 and 1985 taxation years in question, but also in the previous years 1982, 1983 and the subsequent year 1986. In all of these years, the mothballed printing shop produced little if any gross income and suffered continuing losses. In such circumstances, says the respondent, one may reasonably conclude that, specifically with respect to taxation years 1984 and 1985, the printing shop had no reasonable expectation of profit, that the appellant’s source of income came exclusively from his employment and that the shop expenses were incurred by the appellant for his personal use or benefit.

The respondent concludes that such expenses are personal or living expenses as defined in subsection 248(1) of the Income Tax Act. Consequently, they are not deductible pursuant to paragraphs 18(1)(a) and 18(1)(c) of the Act.

Statutory provisions

Subsection 248(1) reads as follows:

Personal or Living Expenses—’ personal or living expenses" includes:

(a) the expenses of properties maintained by any person for the use or benefit of the taxpayer or any person connected with the taxpayer by blood relationship, marriage or adoption, and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit,

(b) the expenses, premiums or other costs of a policy of insurance, annuity contract or other like contract if the proceeds of the policy or contract are payable to or for the benefit of the taxpayer or a person connected with him by blood relationship, marriage or adoption, and

(c) expenses of properties maintained by an estate or trust for the benefit of the taxpayer as one of the beneficiaries;

Subsection 18(1) reads as follows:

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;

(h) personal and or living expenses of the taxpayer except travelling expenses (including the entire amount expended for meals and lodging) incurred by the taxpayer while away from home in the course of carrying on his business;

It will be noted that the statute has a negative approach to any deduction from income. The opening words of subsection 18(1) make this clear: no deduction may be allowed except to the extent that it was made or incurred for the purpose of gaining or producing income from a business or property.

Although the definition of “business” in subsection 248(1) of the Act does not specifically qualify a business as being one in which a project is realized or in which there is a reasonable expectation that a profit will come out of it, the principle is found in the definition of "personal and living expenses" in subsection 248(1) where there is found the expression ”. . .in connection with a business carried on for profit or with a reasonable expectation of profit".

What is a reasonable expectation of profit has been the subject of much case law and has mostly involved the determination of farm losses under section 31 of the Act. Farm losses incurred by what Revenue Canada suspects as being gentlemen farmers are routinely scrutinized whenever farm losses accumulate and are charged off to the individual's other income. Section 31 was meant to curtail the use and enjoyment of lush farm properties as a business-loss source of deductions, with the Canadian public effectively subsidizing up to a half of these losses. It didn't sit well for the public to share in the cost of a bucolic life style complete with prize cattle, swimming pool and open bar on weekends.

There are of course special rules governing farm losses under section 31. They do not necessarily affect farmers whose sole occupation and source of income is farming. It particularly affects people who lose money in farming but charge them against other income. Revenue Canada takes a continuing jaundiced view of tax returns whenever such farm losses are claimed.

It is out of a series of cases dealing with such losses that the concept of “reasonable expectation of profit” evolved. It was articulately expressed b Dickson, J. of the Supreme Court of Canada, in the oft-quoted case of Mola- owan v. The Queen, [1978] 1S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213 at page 485-86 (C.T.C. 313, D.T.C. 5215), where he said:

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered: the profit and loss experience in past years, the taxpayer's training, the taxpayer's intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowances. The list is not intended to be exhaustive. The factors will differ with the nature and extent of the undertaking.

[Emphasis added.]

The requirement that the test be an objective one was respected in a number of tax cases, including Radies v. M.N.R., [1978] C.T.C. 2601, 78 D.T.C. 1448 (T.R.B.), and Shiewetz v. M.N.R., [1979] C.T.C. 2291, 79 D.T.C. 340 (T.R.B.). In the latter case, it was suggested that one cannot rely on subjective expressions of opinion, however sincere.

There is also another line of cases, such as Warden v. M.N.R., [1981] C.T.C. 2379, 81 D.T.C. 322 (T.R.B.), which appear to restrict somewhat the concept of a "business", which is to say that in the absence of a reasonable expectation of profit, it cannot be said that expenses incurred have a“ business" purpose, as provided in paragraph 18(1)(a) of the statute. This is a severe restriction on loss deductions, but is in keeping with the tenor of section 18, which denies deductions unless expressly allowed.

Findings

I view the appellant's approach to the problem with some degree of understanding. In essence, he maintains that rightly or wrongly, he made a conscious decision to maintain his shop with its attendant equipment maintenance costs, rental payments and other recurring expenses, in order to enable him to return to his own business and not depend on outside employment. In so doing, he incurred losses. Yet, one must keep in mind that even if these losses were deductible from his employment income, there still remained to him an after-tax loss of anywhere from 50 per cent to 65 per cent on each dollar lost. Any astute taxpayer would suffer these after-tax losses only if he were perfectly convinced that he had to absorb these losses if he were to realize his ambitions.

Furthermore, the appellant suggests that in the meantime, it cannot be said that the closed shop produced any kind of benefit to him. The Court takes notice of the experience of a single motorhome leasing business or a single yacht charter operation, where the total annual costs of operations greatly exceed rental or charter income and, whether on land or on sea, the owner enjoys the benefits and then claims sizeable deductible expenses. Courts have made short shrift of these cases.

In all such cases, the test of a reasonable expectation of profit cannot be prospective, but retrospective. One cannot presume that when a taxpayer enters into a business venture, it is with the expectation that he will be operating it at a loss. I am not talking here of obviously gimmicky schemes which have merited reassessments, but of more legitimate instances where over a period of time, i. e., with start-up costs, a venture will suffer a loss for some time and ultimately produce a profit. I am referring to all of the surrounding circumstances, including the history of profits and losses as outlined in the Moldowan case, supra, when an objective determination, albeit ex post facto, of the reasonableness of the profit expectation can be made.

In essence, therefore, the appellant's proposition is as follows:

1. He closed his shop because of its marginal returns due to a downturn in the economy or the entry of new printing technology.

2. He nevertheless kept his equipment, paid the rent and telephone with the expectation that circumstances would change to justify a return to his private business.

3. The losses he incurred did not carry the element of" benefit”, a necessary ingredient of personal and living expenses in subsection 248(1) of the Act.

4. If the claimed expenses are not personal and living expenses, they must therefore be categorized as business expenses.

Would that the scheme of Canadian tax law be that simple. First of all, section 18 of the statute limits deductions to those expenses incurred for purposes of earning income from a business.

Secondly, if a business is not being conducted at all, it cannot be said to be a business; it must “involve more than a passive holding of a property as in investment" (see Vern Krishna, The Fundamentals of Canadian Income Tax, 3rd ed., Toronto: Carswell, 1989, pages 213-15).

Thirdly, with all due respect for the appellant, his argument on the issue of reasonable expectation of profit is seriously flawed. There can be no reasonable expectation of profit when a business has ceased operating. Furthermore, I fail to see where the appellant's business interruption is akin to the result of a fire or of a labour conflict. The record of operations for the years preceding and subsequent to the years in question make such a comparison ill-matched.

Fourthly, on the issue of" use of or benefit to a taxpayer", I find that it is not a material element in determining whether a business loss, as in the case before me, is allowable as a deduction. In any event, it might be suggested that such a deduction would otherwise be in the nature of a benefit to a taxpayer.

Conclusion

I must conclude that the taxpayer's appeal be dismissed. I have recognized, however, that the appellant, in pleading his own case, did so in a manner which was far from obstructive. Nor did he impose on counsel for the respondent and on the Court the need to suspend the normal rules respecting the conduct of trials. For that, the plaintiff should be commended.

I should observe that the appellant raised substantial arguments with respect to his assessments and which, in the light of the somewhat novel situation of fact, were ingenious and deserving that they be as fully traversed as possible. In sum, it might be argued that the Income Tax Act should provide some form of relief to a taxpayer in the appellants situation, and thereby provide, as the appellant puts it, justice to the cause. That is policy issue, however, within the exclusive competence of Parliament and which cannot be the subject of Court intervention. In the meantime, my reading of the provisions of the Income Tax Act provides him with no relief.

The appeal is dismissed with costs if demanded.

Appeal dismissed.