Colin Darnel v. Minister of National Revenue, [1988] 2 CTC 2099, 88 DTC 1492

Rip, T.C.J.:—Colin Darnel, the appellant, appeals from notices of reassessment issued by the Minister of National Revenue, the respondent, in which the Minister disallowed business losses of $10,867 and $19,495 for 1981 and 1982, respectively, on the basis that the operation by the appellant of Kea Video Rental Services ("K.V.R.S.") was not a business and thus the expenses incurred by him were personal or living expenses within the meaning of section 248 of the Income Tax Act ("Act").

Mr. Darnel received his Bachelor of Arts degree from the University of British Columbia. He has a marine certificate as a qualified captain of a Canadian ship. For the past 16 years he has worked as a marine pilot, piloting ships in British Columbia waters. As a marine pilot during the years in appeal he would work, or be on call, twenty days a month and have ten days off.

Mr. Darnel has been involved in many adventures during the course of his lifetime. He states he is presently a manufacturer and distributor of pharmaceuticals in British Columbia. He also said he has lectured in Far East affairs and has published a magazine entitled “Pacific Pilot”, which is no longer being published. In 1965, he carried on business as a ship chandler in Vancouver supplying tug boats. He helps his wife operate a hardware business known as Good Neighbour Hardware in Vancouver.

In June of 1978 Mr. Darnel registered a sole proprietorship under the name and style of Kea Video Rental Services and commenced operating the venture. K.V.R.S. was originally conceived to rent films to ships for the entertainment and education of crews by means of video tape or cassette records. Mr. Darnel wrote various shipping companies offering tapes for rent. He immediately encountered logistical problems supplying tapes to ships throughout the Pacific rim and so changed the direction of his operation in mid 1979 to the domestic market. He purchased video tape recorders as well as Super-8 film and increased his library of pre-recorded tapes on both Beta and VHS formats for rental to the public. He said he foresaw video rentals as “a thing of the future” which would be a profitable venture.

In July of 1979 Mr. Darnel caused a corporation, Kea Film Shops Ltd. ("Shops"), to be incorporated. The purpose of this corporation was to rent directly to the public the equipment and tapes owned by K.V.R.S. Shops paid K.V.R.S. a fee for the rentals of equipment and tapes, which Mr. Darnel believed was approximately 20 per cent of the rentals. There was no written agreement between Shops and K.V.R.S. setting out the terms and conditions of the payments.

According to Mr. Darnel during the years in appeal K.V.R.S. owned seven cassette projectors, two or three Super-8 projectors, three or four screens, approximately nine video tape recorders, approximately six Polaroid cameras, overhead projectors, seven or eight video cameras and a Super-8 camera.

In 1979 Mr. Darnel caused Shops to open a retail outlet in Prince George, British Columbia. He was familiar with the town of Prince George which, at the time, according to Mr. Darnel, was “booming” and had a young population. There was only one other camera shop in the town and Mr. Darnel saw lots of room for the new business, which would also include the sale of and developing films. He said costs of advertising were low and Shops advertising on local television and by means of distribution of brochures.

Mr. Darnel says he planned that once the Prince George store was profitable he would open up stores throughout the province of British Columbia. He testified that he had looked into the possibility of stores in Prince Rupert as well as Kamloops and other towns in British Columbia.

At first the business started slowly but within six months it "picked up" and Mr. Darnel was delivering materials as far north as Fort St. John in British Columbia. However at the end of the first year the economy in the region declined to the extent the retail outlet was not viable.

After the summer of 1980 the store was closed. In Mr. Darnel's view, if he could have carried on in Prince George for another year or so, the business would have survived. He insisted the business was a little ahead of its time since video tape recorders were only starting to reach the home market. He also explained the video tape recorders in use in the early 1980’s were extremely heavy and therefore difficult to transport. In short the video revolution had not yet started. Once the store in Prince George was closed the equipment and tapes were moved to the family hardware store in Vancouver. Film was rented through the hardware store as well as through a small store which was rented close to the hardware store.

Mr. Darnel stated that when he moved his equipment and tapes from Prince George to Vancouver he had no clear idea of what he was going to do; there was a period of indecision with respect to the venture. During this period of indecision, which Mr. Darnel sometimes referred to as a transition period, Shops continued to pay rent for the Prince George facility for August, September, October, November and December notwithstanding that he no longer occupied the premises. In 1982, Shops paid $2,001 in rent for the premises.

While still at Prince George, Mr. Darnel hired one Monica Daniel to assist him. Her duties were to find prospective customers for K.V.R.S. and advise on retail sales. Apparently K.V.R.S. had equipment, a telecine, which could transfer photographs and photographic slides to a video tape. Miss Daniel made personal calls and letter solicitations to prospective clients. Miss Daniel was not engaged as an employee of Mr. Darnel. She was paid a fee equal to what she and Mr. Darnel thought was necessary for living expenses; he paid to her the sum of $11,278.53 and $4,219.76 as commission in 1981 and 1982 respectively.

K.V.R.S. never made a profit. The income, expenses and losses for K.V.R.S. were as follows:

The fiscal year of K.V.R.S. ends on July 31.

During the course of cross-examination Mr. Darnel was unable to answer questions put to him by counsel for the Minister in respect of financial matters stating that either his wife took care of the financial end of the business or that the respondent's officials had audited him and the answer to the questions were within the knowledge of the counsel for the Minister.

The largest income earned by the venture was $1,675 in 1982. But in 1982 Mr. Darnel suffered the theft of $7,000 worth of equipment, including a three-quarter inch cassette recorder which was required for commerical clients.

Mr. Darnel stated that he did not insure his equipment because insurance cost was prohibitive, probably about double the cost of the equipment he wished to insure. Such a large expenditure was not justified by what was happening at the time. He also thought at the time that the location where the equipment was kept was not in an area that had a reputation for theft.

Mr. Darnel also testified that when the theft of his equipment took place the rental business was a "dog fight" and he would have to wait out an indefinite period until things settled down. He said various stores were coming on the market and each one was undercutting the other.

In the meantime the technology of video cassette recorders and tapes was rapidly advancing. The new video cassette recorders were smaller and lighter than the ones Mr. Darnel owned and he did not have sufficient funds to replace his old equipment.

Mr. Darnel testified that he never used the video cassette recorders for his own personal use and that he had no television set in his residence.

Mr. Darnel testified that while the store was open in Prince George he would travel there approximately once a month. He said that he also spent his three-month holiday in Prince George. The venture is still being operated today in Vancouver although very modestly. He said that he had stopped renting films through the hardware store in 1983 and is presently working from his house through word-of-mouth advertising.

In 1983 Mr. Darnel started the manufacture and distribution of a herbal laxative to drug stores in British Columbia. He stated that he started working on this laxative in 1981 and that it took two years to get to market. His product was produced by himself. The pharmaceutical identification number for the product was received by Mr. Darnel from the Department of National Health and Welfare in 1982, a factory was set up in Vancouver for the manufacture of the product in July of 1983 and manufacturing commenced in 1984. When he started the venture he anticipated losses for 1983 in the amount of $62,000; the loss was slightly greater. In 1985 the new operation had income of $417 and expenses of $7,045. In 1986 income from the pharmaceutical products was $428 and expenses were $7,112. He acknowledged that during the years under appeal, he devoted a "good deal of time" to the pharmaceutical business. He said his work in the video rentals did not require too much of his time since it was done through the hardware store with the hardware store personnel. The losses in K.V.R.S. took place at the same time the drug product was being developed.

When he commenced the rental operation Mr. Darnel did not make any projections nor did he make any projections in respect of any franchises he hoped would result from a successful store in Prince George. He made his own market study interviewing people living in Prince George.

The operating results of Shops were not more encouraging than those of K.V.R.S.: it also experienced losses from operations. In 1980, 1981 and 1982 Shops had net losses of $11,259, $7,846 and $520 respectively. In 1981 and 1982 Shops deducted the amounts of $665 and $1,675, respectively, which were paid to K.V.R.S. for equipment rental.

There was one piece of equipment that was never rented to Shops and was used by K.V.R.S. for its clients. This was the telecine which was used to convert or transfer photographic and slide material onto video tape. Mr. Darnel was trying to market the concept of transferring photos and slides to video tape as a promotional tool to businesses in Vancouver.

Miss Daniel testified that she commenced working with Mr. Darnel in August of 1980. Prior to that she had worked for seven to eight years in the record and audio tape business which she owned and then sold. She described Mr. Darnel as a good friend and when she wanted a change from the retail trade, Mr. Darnel agreed to use her services to promote K.V.R.S. Her main goal, as she put it, was to create a need for the telecine service. She was successful in selling the service to several businesses, including Chevron Oil.

When the retail business was being carried on in Prince George, she visited the Prince George store to help revive the business.

Miss Daniel, who I found to be a credible witness, stated that she took a film-making course at the British Columbia Institute of Technology so she would know what she was talking about when she spoke to potential clients. She stated that at the time the telecine application was not known and she had to explain the procedure to each potential client.

She testified that most of the cassette rentals at the time went through the hardware store. She corroborated Mr. Darnel's evidence that the equipment that he had was old, and in particular the video cassette recorders were extremely heavy and difficult to carry; she was unable to carry such equipment without assistance. New, lighter machines were coming on the market.

In her view the telecine was not successful because it was “before its time". I have no doubt that Miss Daniel tried diligently to promote Mr. Darnel's activities.

Mr. Virgil Crown, presently an audio-visual producer for London Drugs in Vancouver, also testified on behalf of the appellant. In 1980 Mr. Crown was a retail manager for an electronic firm in the city and in the later half of 1980 started his own audio-visual business. Mr. Crown has technical experience in his line of work, having been employed with the Canadian Broadcasting Corporation in Vancouver and Walt Disney Studios in California. Mr. Crown has known Mr. Darnel as a friend since 1970.

In 1979 Mr. Crown discussed with Mr. Darnel new uses for video and informed Mr. Darnel he had received many enquiries as to the possibility of transferring 8 mm film to video. He saw a need for the telecine concept and in particular the three-quarter inch industrial format film. At the time this service was not being offered to industrial clients and therefore he thought there was an untapped market. At the time the process was extremely expensive and was only used by such organizations as the Canadian Broadcasting Corporation. He had sold only two telecine devices in his business but based on research consisting of phone calls from people who wished to rent the equipment he thought it should be a profitable business. He therefore recommended to Mr. Darnel that such a business had a good potential and sold him the equipment.

As part of his sales incentive Mr. Crown agreed to train K.V.R.S. and Shops staff for use of the telecine equipment. He went to Prince George and trained two of the employees working in the store at the time as well as Miss Daniel. Training consisted of a two hour session with a subsequent "followup".

Under cross-examination Mr. Crown stated that if Mr. Darnel had not purchased the machinery he himself was thinking of going into the business of renting telecine machines.

Prior to entering the K.V.R.S. venture Mr. Darnel had no video experience. He stated that he was not interested in the machinery as such but in the impact the machinery would have.

In many appeals where a taxpayer claims losses from a purported business, the Minister’s position is that the property in respect of which the expenses were incurred was maintained by the taxpayer for his, or his family’s, use or benefit and not maintained in connection with a business carried on for profit or with a reasonable expectation of profit; subsection 248(1) provides that expenses incurred on such property are “personal or living expenses". The Minister has based his assessments on the fact the expenses incurred by the appellant in the operation of K.V.R.S. were personal or living expenses within the statutory definition.

The uncontradicted evidence of Mr. Darnel was that he did not have a television set in his home. It is therefore difficult, if not impossible, for me to find that Mr. Darnel maintained video tapes, video cassette recorders or the telecine for his own use. One of the questions I must decide is whether he maintained these properties for his benefit, that is, for his advantage, profit or good. The maintenance of any property owned by a taxpayer for the purpose of earning income from the property or for the use of the property in a business normally would be for that taxpayer's benefit. Mr. Darnel's evidence was that he purchased the properties to earn income from rentals; I accept his evidence. He did maintain the properties for his benefit, however probable or improbable the benefit may be.

The real question is whether the properties were maintained by Mr. Darnel in connection with a business carried on for profit or with a reasonable expectation of profit? The evidence is clear that if a business did exist, no profit was ever made. Was the business ever susceptible of making a profit? In other words was the business carried on with a reasonable expectation of profit?

I have no doubt that Mr. Darnel was sincere and his efforts to start K.V.R.S. and make it a profitable venture were in good faith. The question in my mind is whether his K.V.R.S. venture ever had a chance to get off the ground.

Mr. Justice Addy wrote the following in W. Chequer v. The Queen, [1988] 1 C.T.C. 257 at 259; 88 D.T.C. 6169 at 6170:

However, the plaintiff is obliged to go much further than demonstrate good faith. There exists a burden of proof on every taxpayer who claims a deduction of net losses resulting from a business adventure, to establish that there was, at the time that he engaged in and carried on with the business, a reasonable expectation of profit. The reasonableness of the expectation must be viewed objectively and cannot merely consist of an expectation which the taxpayer in good faith entertains to the effect that a profit will eventually be realized.

As Chief Justice Dickson (Justice Dickson as he then was) stated in the case of William Moldowan v. The Queen, [1977] C.T.C. 310 at 313; 77 D.T.C. at 5215:

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 allowance. The list is not intended to be exhaustive. The factors will differ with the nature and extent of the undertaking: The Queen v. Matthews, [1974] C.T.C. 230; 74 D.T.C. 6193. One would not expect a farmer who purchased a productive going operation to suffer the same start-up losses as the man who begins a tree farm on raw land.

[Emphasis added.]

The same principle regarding the objective nature of the test was recently applied by my brother, Strayer, J. in the case of Meech v. The Queen, [1987] 1 C.T.C. 421; 87 D.T.C. 5251.

The evidence does not reveal the extent of Mr. Darnel's market study, in particular, whom he spoke to and the basis of the advice he received. He testified that in 1979 there was only one other camera store in Prince George and therefore he saw lots of room for the new business. However there is no evidence to show that K.V.R.S., and not Shops, sold any film and cameras.

Mr. Darnel testified no projection had been made prior to the start of this activity. There is no evidence as to how much capital would be required for Mr. Darnel to invest before the venture became profitable, if he had such capital available, or if he was prepared to invest such an amount in this venture. I would have expected some calculations to have been made, even informally, when he made a decision to rent facilities in Prince George, for example. He had no knowledge as to any figures to establish that he had calculated that there was a reasonable expectation of profit. He testified that anything financial was within the knowledge of Mrs. Darnel or, because of their audit, officials of the respondent. Mrs. Darnel was not called to testify.

Mr. Darnel was not questioned how in future years he expected to increase his income or decrease his expenses to show a profit. He said by 1980 his equipment was becoming obsolete. I cannot imagine — since there was no evidence on this point — how he expected to show a profit in future years when the equipment would have aged even more. If the hopes for success rested in the telecine equipment there was no projection confirming the validity of such hopes and when such hopes may have been realized. While telephone inquiries demonstrate a general interest in using telecine, the extent of the interest depends on cost and quality of the service, and there was no evidence of either.

To be successful in his appeals Mr. Darnel must establish objectively that there was a reasonable expectation of profit. He has failed to show that the venture was reasonably capable of a profit. The expenses incurred on the properties, including the cassettes, video cassette recorders, and the telecine, although not expended as part of Mr. Darnel's lifestyle, were nevertheless personal or living expenses as defined by the Act.

The appeals are dismissed.

Appeals dismissed.