Frank L. Stromotich v. Minister of National Revenue, [1986] 1 CTC 2105, 86 DTC 1032

Sarchuk, T.C.J.:—The appeal of Frank L. Stromotich, (Stromotich) relates to the 1983 taxation year. The respondent, in reassessing the appellant, did not take into account when calculating his liability for tax in that year any amount of business investment tax credit, maintaining that there was no amount of such credit available to the appellant because the appellant made no qualified expenditures within the meaning of paragraph 127(10.1) of the Income Tax Act in the 1983 taxation year and had no amount of business investment tax available to be carried forward to the 1983 year from his previous taxation years pursuant to subsections 127(5) and 127(9) of the Income Tax Act.

Subsequently the respondent conceded that Stromotich is entitled to the benefit of a business investment tax credit in the amount of $1,310.33 carried forward from the 1978 to 1981 taxation years, inclusive, which is to be applied to the appellant's 1982 taxation year in conformity with the appellant's request and that the said $1,310.33 ought to be taken into account in determining the appellant’s income for the 1982 year, in accordance with the provisions of paragraph 12(1 )(t) of the Act.

I note that although the respondent consented to applying this particular amount to the appellant’s 1982 taxation year at trial the appellant sought a different application of this amount. This matter will be dealt with in due course.

The appellant’s position can best be set out by reproducing a portion of his Notice of Appeal:

STATEMENT OF FACTS

1. That the Appellant filed a Notice of Objection on January 21st, 1985, and at no time during 90 day period following did Revenue Canada give any indication of intent to process the appeal, and now that the 90 day period has expired the Appellant would like his appeal heard before the Tax Court of Canada — specifically to be adjoined to his appeal hearing No. 85-120(IT), commencing in June 1985.

2. Although in a Notice of Assessment dated December 31st, 1984, the tax department indicated they were processing the B.I.T.C. for the prior year 1982, leaving the Appellant to conclude that 1983 was in process, neither were being processed and in fact telephone enquiries confirmed on February 7th, 1984, that 1983 had been rejected.

3. The Appellant appealed to the Director, for the processing of 1983 B.I.T.C.; however, the Director chose to obfuscate; the Appeals officer to claim his hands were tied by the appeal to the Tax Court; and the Chief of Collections by claiming that any action on his part would nullify my case before the Tax Court. However, no division would put a statement of their position in writing.

4. A proper Notice of Objection was filed January 21st, 1985, and Appeals should have contacted the Appellant directly. The continuing delays by the Taxation Division and by Appeals are principally cash flow related — onerous for the Appellant but an added enhancement for the Tax departments.

5. In summary, this appeal is recover the B.I.T.C. that should have been processed in with the Assessment claimed in November 1984.

For B.I.T.C. on Scientific Research expenditures incurred:

1) For 1977 for $92.08

2) For 1978 for $207.79 plus $44.53

3) For 1979 for $743.63

4) For 1980 for $1,280.27

5) For 1981 for $1,028.07

6) For 1982 for $1,776.10

7) For 1983 for $456.22 plus $2,161.99

Specifically, items 1-4 were carried forward and claimed in as follows:

8) For 1982 in the amount of $3,211.87

9) For 1983 in the amount of $4,557.00.

Items 8 and 9 constitute the Appellant’s claim to the Tax Court.

In assessing the appellant for his 1983 taxation year the respondent accepted the taxable income reported by the appellant for that year but did not take into account in determining the income tax for which the appellant was liable the business investment tax credits which the appellant had requested for his 1982 and 1983 taxation years. In so assessing and in conceding that the appellant is entitled to a business investment tax credit of $1,310.33 to be applied in the 1982 taxation year the respondent relied upon the following assumptions in paragraph 11 of his reply to notice of appeal:

(a) during the 1977 to 1981 taxation years, inclusive, the Appellant was engaged in scientific research, within the meaning of Regulation 2900 of the Income Tax Regulations, in connection with inventing activities he was carrying on in his spare time at his personal residence;

(b) during the 1982 and 1983 taxation years the Appellant was engaged in a sideline business in connection with his inventing activities but he was not engaged in scientific research within the meaning of Regulation 2900 of the Regulations;

(c) in his returns of income for the 1977 to 1983 taxation years the Appellant reported business expenses in connection with his inventing activities in the following amounts:

1977	$ 1,704.02
1978	4,496.64
1979	7,056.23
1980	11,029.96
1981	10,332.97
1982	17,777.42
1983	15,892.59

particulars of which amounts are set out in Schedule 1 to this Reply;

(d) in his return of income for the 1977 taxation year the Appellant applied for and was allowed a business investment tax credit in the amount of $85.20 to be applied in the 1977 year, based upon scientific research expenditures made by him in that year of $1,704.02, and his subsequent claim for a business investment tax credit in respect of expenditures made in that year must be reduced accordingly by that amount;

(e) in the 1983 calendar year the Appellant applied for business investment tax credits to be applied in the amount of $3,211.87 in the 1982 taxation year and $4,557.00 in the 1983 taxation year and indicated his intention that the amounts of such credit to be carried forward from the 1977 to 1981 years, inclusive, should first be applied in the 1982 year and the balance carried forward to 1983, and he claimed the following amounts of business investment tax credit for the 1977 to 1983 taxation years inclusive, based upon the following amounts of scientific research expenditures made by him in those years:

	S.R.E.	Rate	I.T.C. LT.C.
1977	$ 1,841.64	x 5%	$ 92.08
1978	4,601.10	x 5%	252.32
1979	7,436.30	x 10% =	743.63
1980	12,802.70	x 10% =	1,280.27
1981	10,280.70	x 10% =	1,028.07
1982	17,761.00	x 10% =	1,776.10
1983	15,372.15
	($ 4,562.20)	x 10% =	456.22
	($10,809.95)	x 20% =	2,161.99;

(f) of the business expenses reported by the Appellant in his returns of income for the 1977 to 1983 taxation years, inclusive, and referred to in paragraph 11(c) of this Reply, the following amounts were prescribed expenditures within the meaning of Regulation 2902 of the Income Tax Regulations and for which he claimed the following amounts of business investment tax credit:

	P.E.	Rate Rate	I.T.C.
1977	$ 888.72	X 5%	$ 44.44
1978	1,385.23	X 5%	75.97
1979	2,060.51	x 10% =	206.05
1980	9,197.28	x 10% =	919.73
1981	7,922.14	x 10%	792.21
1982	15,846.76	x 10% =	1,584.68
1983	12,399.87	x 10% =	1,239.99;

based upon the calculations set out in Schedule 2 to this Reply;

(g) the amounts of prescribed expenditures which are set out in paragraph 11(f) of this Reply are not qualified expenditures within the meaning of paragraph 127(10.1)(c) of the Income Tax Act and the Appellant is not entitled to a business investment tax credit for scientific expenditures in respect of the said amounts;

(h) because the Appellant was not carrying out scientific research in the 1982 and 1983 taxation years the expenditures in the amounts of $17,761.00 and $15,372.15 in respect of which he claimed business investment tax credits of $1,776.10 and $2,618.21, respectively, are not expenditures in respect of scientific research and they are not qualified expenditures within the meaning of paragraph 127(10.1 )(c) of the Income Tax Act and the Appellant is not entitled to a business investment tax credit in respect of them;

(i) the following amounts of business investment tax credit are applicable to the business investment tax credit claimed and allowed in the 1977 taxation year referred to in paragraph 11(d) of this Reply, and to the reported expenditures which are not qualified expenditures, referred to in paragraphs 11(f), (g) and (h) of this Reply, and the Appellant’s claim for business investment tax credits must be reduced accordingly as follows:

	1977	1978	1979	1980	1987	1982	1983
I.T.C.
claimed by
Appellant	$92.08	$252.32	$743.63	$1,280.27	$1,028.07	$ 1,776.10 $ 2,618.21
Less:
-I.T.C.
previously
claimed and
allowed	(85.20)
-I.T.C.
claimed on
prescribed
expendi
tures	(44.44)	(75.97)	(206.05)	(919.73)	(792.21)	( 1,584.68) ( 2,111.97)
-1.T.C.
claimed on
expendi
tures not
incurred for
scientific
research	—	—	—	—	—	(*1,776.10) (*2,618.21)
(*includes
I.T.C.
claimed on
prescribed
expendi
tures)
Balance	Nil	176.35	537.58	360.54	235.86	Nil	Nil

(j) the Appellant had from the 1978 to 1981 taxation years, inclusive a business investment tax credit in respect of scientific expenditures in the amount of $1,310.33 available to be carried forward and applied in conformity with the Appellant's application firstly to the 1982 taxation year and no remaining business investment tax credit in respect of scientific expenditures available to be applied secondly to his 1983 taxation year; and

(k) in the 1982 and 1983 taxation years the Appellant had no scientific research expenditures for which he was entitled to claim a deduction from his taxable income pursuant to subsection 37(1) of the Income Tax Act and any amount of business investment tax credit deducted by him pursuant to subsection 127(5) of the Income Tax Act in either year must be taken into account in calculating his taxable income for the year; and

(l) in the 1977 to 1983 taxation years, inclusive, the Appellant was not a taxpayer who derived all or substantially all his revenue from the prosecution of scientific research or the sale of rights in or arising out of scientific research carried on by him.

During the course of his testimony Stromotich was cross-examined with respect to the calculations made by the respondent relating to business expenditures and prescribed expenditures (Schedule 1 to the respondent's reply*) [1] and investment tax credit for scientific research expenditure (Schedule 2 to the respondent's reply*). He conceded that the calculations were correct but rejected the respondent's position that the prescribed expenditures were not qualified expenditures within the meaning of Regulation 2902.

The appellant’s claim for business investment tax credits can succeed only if he brings himself within the provisions of several sections of the Income Tax Act. Subsection 127(5) provides for an investment tax credit which is deductible from tax otherwise payable for a taxation year. Subsection 127(9) defines investment tax credit and provides the pool of qualified expenditures in respect of scientific research upon which the investment tax credit is calculated.

Paragraph 127(10.1)(c) defines a “qualified expenditure" as:

(c) “qualified expenditure" means an expenditure in respect of scientific research made by a taxpayer after March 31, 1977 that qualifies as an expenditure described in paragraph 37(1)(a) or subparagraph 37(1)(b)(i), but does not include a prescribed expenditure; .. . [Emphasis added.]

Regulation 2902 must also be complied with. The relevant portions of this Regulation read:

2902. For the purposes of paragraph 127(10.1)(c) of the Act, a prescribed expenditure is

(a) an expenditure of a current nature incurred by a taxpayer in respect of

(i) the general administration or management of a business, including

(A) an administrative salary or wages and related benefits in respect of a person whose duties are not wholly directed to the prosecution of scientific research,

(B) a legal or accounting fee,

(C) an amount described in any of paragraphs 20(1)(c) to (i) of the Act,

(D) an entertainment expense,

(E) an advertising or selling expense,

(F) a convention expense,

(G) a due or fee in respect of membership in a scientific or technical society or organization, and

(H) a fine or penalty, or

(ii) the maintenance and upkeep of premises, facilities or equipment to the extent that such expenditure is not attributable to the prosecution of scientific research,

except any such expenditure incurred by a taxpayer who derives all or substantially all of his revenue from the prosecution of scientific research or the sale of rights in or arising out of scientific research carried on by him; ... [Emphasis added. ]

Reference to Schedule 1 of the respondent's reply establishes that Stro- motich included accounting and legal expenses, advertising and promotion, convention costs, interest expense and rent. Therefore the provisions of Regulation 2902 apply unless the appellant can exempt himself from its application by establishing that he derived all or substantially all of his revenue from the prosecution of scientific research or the sale of rights in or arising out of scientific research carried on by him.

The appellant summarized his position on this issue as follows:

I am going to continue, Your Honour, on a few points with regard to Regulation 2902 and the wages of a taxpayer as being the total income.

I think to go beyond the business, it must be impossible to establish the bounds, but I am sure if somebody could arbitrarily draw the bounds, is, how many businesses can be included in this normal revenue. Okay. I think, though, when you have to look at scientific research too, and as to whether or not that it was intended that business investment tax credit be applied for the benefit of taxpayers for funding research, one has to recognize the if you don't just confine it to the company or the business, then at what point do you say, “those are not expenditures related to the marketing of that technology’’?

“Anything prior to that doesn't apply, anything prior to the application to the licensing phase doesn't apply.” It is only when you get down to the licensing phase that the tax credit should apply. I think that those are all sorts of ramifications of that kind of decision, as to taking a broad perspective of the taxpayer when he is an individual and taking a specific perspective when he is a corporation.

I think that if the broader perspective was used then that introduces another accounting feature to offset the broader perspective. I cited the case of paying myself $100,000 a year. Then my scientific research expenditures, or wages, would be much higher than my ordinary wages. I cited also that in a case where you looked at wages and said the guy was working in scientific research, and I take the position clearly, I am not working in scientific research for my wages.

I am saying it is irrelevant whether I am working for wages or not, in scientific research that cannot determine in anybody's mind that I am entitled or not entitled to those credits that apply to a business of my own, that I am engaging in, in scientific research.

I cited there are lots of other complications to that, whether your employer is doing that, got any credit or sold any of the technology that you have developed for him, all of those things. It has got really nothing to do with the person who runs another business and provides a service to an employer.

The difficulty with Stromotich's position is that in the taxation year 1983 he was employed as an executive engineer with the B.C. Utilities Commission and received a salary of $53,849.60. In that same taxation year his scientific research business had no revenue. In fact in all of the years from 1977 to 1982 inclusive that business had never produced any revenue.

Revenue is defined in Black’s Law Dictionary as:

Return or yield, as of land; profit, as that which returns or comes back from an investment; the annual or periodical rents, profits, interest or issues of any species of property, real or personal; income of individual, corporation, government, etc. Willoughby v. Willoughby, 66 R.I. 430, 19 A.2d 857, 860.”

Revenue is a broad term, and appears to mean all the amounts received by a taxpayer from all sources. Reference to subsection 248(1) of the Act and the definition of “gross revenue” contained therein appears to support the respondent's assertion that the appellant derived no "revenue” from scientific research carried on by him.

On the evidence before me I have no alternative but to conclude that the appellant has failed to establish that he derives all or substantially all of his revenue from the prosecution of scientific research. I am satisfied that the respondent was correct in treating certain of the business expenses reported by the appellant as prescribed expenditures and as such they were properly disallowed.

With respect to those remaining expenditures which can be categorized as qualified expenditures the respondent's position is that they were not deductible because they did not meet the requirements of paragraph 37(1)(a) in that they were not expenditures made on scientific research related to the business and directly undertaken by or on behalf of the appellant.

The term scientific research is defined in paragraph 37(7)(b) of the Act and by Regulation 2900. These provisions read:

37. (7)(b) “Scientific research has the meaning given to that expression by regulation;

2900: For the purposes of this Part and paragraphs 37(7)(b) and 37.1 (5)(c) of the Act, “scientific research” means systematic investigation or search carried out in a field of science or technology by means of experiment or analysis, that is to say,

(a) basic research, namely, work undertaken for the advancement of scientific knowledge without a specific practical application in view,

(b) applied research, namely, work undertaken for the advancement of scientific knowledge with a specific practical application in view, or

(c) development, namely, use of the results of basic or applied research for the purpose of creating new, or improving existing, materials, devices, products or processes,

and, where such activities are undertaken directly in support of activities described in paragraph (a), (b) or (c), includes activities with respect to engineering or design, operations research, mathematical analysis or computer programming and psychological research, but does not include activities with respect to

(d) market research or sales promotion;

(e) quality control or routine testing of materials, devices or products;

(f) research in the social sciences or the humanities;

(g) prospecting, exploring or drilling for or producing minerals, petroleum or natural gas;

(h) the commercial production of a new or improved material, device or product or the commercial use of a new or improved process;

(i) style changes; or

(j) routine data collection. [Emphasis added.]

Counsel for the respondent agreed that in the years prior to 1979 Stromotich was involved in activities with respect to engineering or design and was doing scientific research. The respondent submits however, that following the completion and the patenting of his invention the appellant was no longer doing scientific research but was involved either in activities with respect to market research or in sales promotion.

The respondent relied in part on the notice of objection for 1982 filed by the appellant and on notations in his tax returns for the taxation years 1982 and 1983. These documents, together with the appellant’s evidence, indicated that he had passed out of the three stages of scientific research, being basic research, applied research and development by the end of 1979.

In his notice of objection the appellant stated:

Stromotich objects to the reassessment described in paragraph 11 on the ground that the above facts disclose that his business is developing, improving, and patenting and licensing of planetary drive had effectively commenced by 1979 and was actively and continuously carried on in ’79, "80, ’81 and ’82 taxation years. It is submitted that Stromotich's business had commenced by 1979 because at that time the basic and applied research into an electric drive had been completed. The planetary drive had been successfully developed. Applications for patents had been made. Indications had been received from government authorities that patents would be granted and preliminary marketing studies and negotiations with potential users and licensees had been made. These activities were essential preliminaries to the normal operation of Stromotich’s business of developing and licensing of a planetary drive and were directed to bringing a planetary drive to potential users and licensees. [Emphasis added.]

In conjunction with the foregoing counsel also pointed to the fact that many items of expense which began to appear in the appellant’s statement of income and expense in the 1982 and 1983 taxation years were not related to the carrying on of scientific research but were more directly related to the marketing of a product.

It was difficult to follow the argument advanced by the taxpayer on this issue. Indeed it was difficult to convince the appellant that his bald statement, that he was entitled to the credit unsupported as it was by any acceptable evidence was not sufficient. After some sifting of the various statements made by the appellant the following facts appear to be relevant to the issues before the Court.

The appellant earned a Ph.D. in engineering and has 26 years of experience in his chosen field. His particular interest is in relation to the development of power trains (drive) to power ships. He has been working on this project since 1964. Stromotich described the first stages as basic research during the course of which he investigated, searched and examined the principles of the drive with his peer group. In 1975 he designed a prototype and continued his investigation and research. In 1977 when he believed that his drive was practical and feasible he applied for a Canadian patent. He described the obtaining of a patent as a slow process requiring disclosure of all prior art and the closest technology anywhere. He apparently prosecuted the patent himself and in 1978 was advised that the Canadian patent would be granted. As a result he filed in the United States and that same year applied for a patent in Great Britain. The Court understood Stromotich to say that by 1982 he had received patents for his invention from Canada, the United States and from Great Britain.

He described his business as having commenced in 1975 but he chose to say, without explanation, that it was not a research business. He said that by 1979 the business was ready to attempt to earn revenue and that he hoped to derive a profit by licensing the drive technology. He said “once licensed, you can earn a royalty in many different ways". The most appropriate, from his point of view, would be to have an established entity manufacture the drive. He advised the Court that he could market different applications with different companies since there are nine products associated with the various patents he obtained. This would enable Stromotich to reach the maximum market with each particular application of his invention.

It was evident that Stromotich had maintained close control over his invention since he did not wish to risk possible challenges and litigation in the manufacturing and marketing stage until all of his patents were firmly in place. This was the case by 1982 when he approached Black & Decker. When asked, with respect to the 1983 taxation year, how the business intended to earn revenue Stromotich responded that he intended to license the technology and obtain substantial front-end money to ensure its production.

On the basis of the evidence adduced it is clear that the activities carried on by Stromotich in taxation year 1983 do not come within the meaning of the term “scientific research” as defined in Regulation 2900(a) and (b). Furthermore, on the evidence adduced it is not possible to bring the appellant within the provisions of Regulation 2900(c) as suggested by him. The testimony given by Stromotich and the exhibits filed firmly establish that the activities carried on by him in 1983 were not scientific research, but are more aptly described as market research, sales promotion and activities with respect to the planned commercial production of the device. Although he continued to press for further patents in 1983 this does not bring him within the scope of the provisions of Regulation 2900(c).

As a result the appellant is not entitled to deduct in computing his income for the 1983 taxation year the amounts in question since they were not expended for scientific research.

Since the respondent conceded that the appellant is entitled to a business investment tax credit for scientific research expenditures in the amount of $176.35 in 1978, $537.58 in 1979, $360.54 in 1980 and $235.86 in 1981 for a total credit of $1,310.33 and since in assessing the appellant for his 1983 taxation year and failing to take into account in determining the income taxes for which the appellant was liable the business investment tax credit which the appellant had requested for his 1982 and 1983 taxation years, this appeal is allowed to the extent only that the taxpayer is entitled to the benefit of a business investment tax credit in the amount of $1,310.33 carried forward from the 1978 to 1981 taxation years, inclusive, which will be applied in accordance with the appellant’s directions. In all other respects the assessment is maintained.

The appeal is allowed and the assessment is referred back to the respondent for reassessment in accordance with these reasons.

Appeal allowed in part.