Hugh Joseph Hanlon v. Minister of National Revenue, [1984] CTC 2131, 84 DTC 1101

Tremblay, TCJ:—this case was heard May 13, 1983, at the City of Vancouver, British Columbia.

1. The Point at Issue

The point at issue is whether the appellant, a full-time employee with Emergency Health Services of B.C., is correct in deducting in the computation of his net income for the 1976 and 1977 taxation years the business losses of $2,346.44 and $6,324.26 respectively with regard to Snow Mountain Foods Co.

The respondent’s contention is that the appellant had no gross income in 1976 and only had a gross income of $16.95 for 1977, and the business had no reasonable expectation of profit, and therefore pursuant to the Income Tax Act the said amount must be considered as personal expenses and hence not deductible.

2. The Burden of Proof

2.01 The burden is on the appellant to show that the respondent’s assessments are incorrect. This burden of proof results particularly from several judicial decisions, including the judgment delivered by the Supreme Court of Canada in Johnston v. MNR, [1948] CTC 195; 3 DTC 1182.

2.02 In the same judgment, the Court decided that the assumed facts on which the respondent based the assessments or reassessments are also deemed to be correct. In the present case, the assumed facts are described in the reply to notice of appeal as follows:

4. In so assessing the Appellant for his 1976 and 1977 taxation years, the Respondent relied, inter alia, upon the following assumptions of fact:

(a) That the Appellant was throughout the 1976 and 1977 taxation years a full-time employee with Emergency Health Services of B.C.;

(b) That in addition to his full-time employment, the Appellant carried on a photograph business under the name “Light Image Photoworks’’ during both the 1976 and 1977 taxation years;

(c) That the Appellant had no gross income in 1976 and only $16.50 gross income in 1977 from Snow Mountain Foods Company;

(d) That the expenses claimed by the Appellant with respect to Snow Mountain Foods Company, being $2,346.44 in 1976 and $6,341.21 in 1977, were not incurred by the Appellant for the purpose of gaining or producing income from a business or property;

(e) That the Appellant, during the 1976 and 1977 taxation years, did not carry on a business under the name of Snow Mountain Foods Company for profit or with a reasonable expectation of profit;

(f) That the said expenses claimed by the Appellant with respect to Snow Mountain Foods Company were, as to some, outlays or payments on account of capital, and, as to others, personal or living expenses of the Appellant;

3. The Facts

3.01 The appellant was born in 1953 and is unmarried. Concerning his education, the appellant said he did not graduate from high school but spent 2 /? years in the evenings going to BC University in the faculty of Science and Business: biology, mathematics, management psychology, accounting, management law and computers in business. In sum, he said he was going to school to learn how to be in business. He also learned to speak and write the Japanese language. (SN pp 64, 65, 74 and 79)

3.02 Throughout the 1976 and 1977 taxation years, he was a full-time employee with the Emergency Health Services of BC. He worked four days a week. “It was two day shifts, two night shifts and four days off’. He had been working there until 1981. His salary in 1976 was $19,201.60 and in 1977 it was $17,089.09. (SN pp 71 and 72)

3.03 ‘* because I worked for the ambulance service and I worked in very quiet places, maybe six or seven hours of a twelve-hour shift would be in the station . . .” (SN p 72); therefore he had a lot of time to study and write letters, etc.

3.04 Since 1981, he has been working in construction more particularly in “longshoring and shipbuilding’’ (SN p 63). On the construction site, the appellant worked as first aid attendant. It was an office job with a lot of free time. At the same time during the winter 1981-82, he designed a “plate heat exchanger flow pattern’’. It was used in dairies to cook things and cool them (SN p 115). During the year 1981, he had a salary income of about $25,000.

3.05 In 1976 and 1977, he carried on a photography business under the name of “Light Image Photoworks’’, and owned a proprietorship called “Snow Mountain Foods Co.*’.

A. Light Image Photoworks

3.06 The expenses concerning Light Image Photoworks claimed for the same years were: $3,200.77 in 1976 and $1,166.97 in 1977 and are not in dispute. They were allowed by the respondent in the reassessments.

B. Snow Mountain Foods Co.

3.07 The evidence concerning Snow Mountain Foods Co. is described on the last three pages of Exhibit A-2. The appellant read them in his testimony(SN pp 25 to 30):

Mr. Hanlon: In July ’76, 1 decided to enter the business of manufacturing — I alternate protein food products via protein concentration or isolation because of the vastly high thermal efficiency possible from the systems versus conventional protein food manufacturing methods for protein (beef grazing feed lot dairy), so it meant an alternative method of food production.

In view of escalating energy costs, I believe that they would be very viable in the future. I decided to concentrate on aqueous vegetable protein extraction methods and commenced research of this topic to the end of manufacturing vegetable protein concentrates or isolates and bean sprouts for human consumption and selling the technical know-how developed as a food industry consultant.

From July ’76 to the present, which was in ’79, that’s the period of ’76 to ’79, I spent an average of ten hours a week researching this topic, developing research contact, supplier contracts, conducting market surveys, touring production facilities, testing materials and processing techniques.

I purchased a packaging machine, 1600 units an hour, a specialized material grinder and a 100 gallon-holding tank.

I have made trips to Seattle, Portland, San Francisco, Los Angeles, Iowa, Honolulu and Tokyo for the singular purpose of developing supply lines, learning techniques and viewing production facilities.

October ’76, I went to Seattle, Portland, to tour small production facilities there, here soy experts speak and copy a draft production manual from a small Japanese plant.

Went to Iowa October ’76 to copy 150 slide consumer-oriented presentations on the value and attractiveness of soya based protein foods and to inquire further about required machinery.

Went to San Francisco, Los Angeles and after the letter, I’ll refer to specific companies that I met in these places in this period of time. That’s what’s on these two pages. There’s about, I guess, 70 companies that were contacted in that period of time, in Japan and United States.

Went to San Francisco, Los Angeles December 25th, 1976, the 8th of January ’77, viewed production facilities San Francisco, negotiated with Okita Enterprises for a production facility which is a complete plant.

And viewed Los Angeles plant, the biggest in North America. Studied product range presentation, pricing and distribution — San Francisco and Los Angeles where four major manufacturers compete for market in Oriental bean cake which is beancurd which is a crude protein isolate, food product.

I continued research through ’77, went again to San Francisco and Los Angeles, August 21st to 30th, 1977, met with owners of two largest San Francisco plants, which are the second and third largest in North America.

Attempted to buy equipment from them, studied the market and supply lines; met with Okita of Okita Enterprises, Los Angeles, who at that time was the only supplier in North America of the machinery or technology.

Met with — I should say the Japanese aspect of it, the soya protein aspect of it.

Met with representatives of Brown Corporation, Sweko Corporation, Seal-rite Corporation, Los Angeles; Rates Corporation, Santa Rose, purchased 360 pounds of test material from Strayor Seed Farms, which referred to material for product — for product manufacture.

In Los Angeles, August let to 30th, bought a packaging machine from Okita, leased it to the farm, a San Francisco company for $500.00 for four months; and I submit that that is a commercial activity.

And the other part of the deal was that I would take ownership of a pasturizer. Like on one side I give them a machine for four months; on the other side, they give me $500.00, a pasturizer and some recipes, plus trade of their soy ice cream recipes and knowledge. Subsequently they did not take delivery of the machine, did not pay and did not turn over their research.

December ’77, negotiated a loan of $11,000 to start business operation on a one year term.

In March ’77 I have, I would assume a misprint, realized I could not go ahead yet because I would not be able to repay to terms if paying for technology. That I’d have to research further and build much of the equipment myself.

October ’77, went to Tokyo and Honolulu on return; met with President of Japan Food Engineers Institute at length; met with representatives of two major equipment manufacturers, one trading company. Toured three large plants employing Japanese — employing modern Japanese equipment and technology.

Honolulu, toured the major Hawaii plant which would be and was the fourth largest in North America. Discussed process with owner, attempted to purchase equipment.

1978, purchased state of the art technology, an anti-bacterial grinder from Mitsuko Sango Industry, Japan; continued testing and design and maturing process.

I’m presently consolidating my research work and plan to develop my marketing plans; for ’79, construct the production facility in 1980 and commence production 1980 or ’81.

My success to date has been excellent in achieving a technological base at a very low cost in an extremely secretive industry.

My inability to earn a profit to date in this business is perhaps a reflection of my youthful and inaccurate conception of the degree of complexity of these enterprises and my lack of previous business knowledge and experience.

In the first full year of full product production I expect to gross $170,000.00, have production expenses of $118,000 and a profit of $37,000.

3.08 As Exhibit A-3 was filed a document giving names of over 60 companies he visited in the United States and Japan.

3.09 Snow Mountain Foods Co was incorporated in 1981 under the name of “Hyperform Holding Corporation”. It has never generated a profit (SN p 19). “It’s typical in that industry to spend ten years to determine whether or not to enter. It’s less than simple and plants — well, the most recently built plant cost $12 /i million and I bought almost a full semi-trailer truckload of machinery from that plant in November of last year for $12,000 approximately at liquidation . . . almost all of the machinery has been bought at a very low price and this has been possible of the legwork done in ’76, ‘77, ‘78 and continuing, where I found out what was going on, and where it was going on. And so one of my points is that the activities at that time were the reason for where I’ve gotten thus far, even though there is still not a profit.” (SN pp 32 and 33)

3.10 A consolidated statement of expenses for the six years ending November 1981 (Exhibit A-5) of Snow Mountain Foods (proprietorship) showed a total amount of $29,137.

3.11 The appellant never had a specified place of business but used the rental location where he was living. He claimed 30 per cent of his rent as business expenses.

3.12 Concerning Hyperform Holding Corporation, the appellant filed many interesting and learned documents:

a. Soy Protein Isolate and Related Soyfood Products — A phase IPDMP Audit carried out on behalf of Hyperform Holding Corporation by Business Assistance Division of BC Research and Burke Corbet Associates, West Vancouver, BC, is dated February 1983 (Exhibit A-1);

b. CASE Counselling Report signed by Counsellor A W Knowles of the Federal Business Development Bank, is dated March 17, 1983 (Exhibit A-6);

c. A proposal Market Assessment and Financial Viability Food Processing Plant signed by Roger Lefrançois of HLA Consultants, is dated August 26, 1982 (Exhibit A-8);

d. A market research study on the introduction of a variety of soybean products to the Pacific Northwest, is dated September 16, 1982 and signed by Price Waterhouse Associates (Exhibit A-9);

e. A feasibility study — Marketing of Soybean Isolate Products, is dated September 7, 1982, and signed by Irwin Woodrow President of Cor-El Food Corporation (Exhibit A-10).

Counsel for the respondent objected to the filing of these documents on the basis that they are all experts’ reports and that the experts were not in Court to explain the reports and to be cross-examined. The Court then permitted the filing of these under reserve for a later decision.

Probably it would have been advantageous for the appellant and for the Court to have a judicial knowledge of these documents. However, the Court must maintain the counsel’s objection. Indeed it is a fundamental right for a party to hear an expert and cross-examine him.

Moreover, the Court states that the appellant had nearly two years to take information and to prepare his case. The appeal indeed was filed in January 1981, and in May 1982 when the case was called for hearing, the appellant asked for an adjournment to prepare his case well.

3.13 In cross-examination, the appellant answered as follows to this question:

Q. Before you started in 1976, I believe it was around July, did you have any expertise in this area at all?

A. Well, I had been thinking of it for quite a few years, maybe six years, and I had what expertise I could glean from observing the Vancouver manufacturers of bean sprouts and a product called tofu, which is about 1600 years old and it’s a major protein food product in most of the population of the world, and it’s quite — it’s crudely manufactured and it’s quite a crude protein product, and that’s about the only exposure I had prior to that.

In ’76 I decided that I was going to make a career and an occupation of it, and I started to spend time in the university library and in conversation with experts in the field. I think in ’76 I first wrote to the Japan Food Engineering Institute. (SN pp 77 and 78)

3.14 In 1976 and 1977, he investigated the isolation of the food products to determine the machinery necessary, the investment necessary, and the profit expectation (SN p 80). In the said years, “I took a lot of training, in the sense of meeting with the owners of the biggest facilities of the world” (SN p 78).

3.15 “The most profound change in food product consumption in North America in ’82 was the six per cent change which was the increase of chicken products. So in normal food products, six per cent was the biggest. The growth rate of this isolate food product for the last three years has been between 30 per cent and 35 per cent.” (SN p 79)

3.16 In 1976, the first modern plant was installed in North America. Then 60 per cent of the raw material was in the end product. “Now I have over 90 per cent.” (SN pp 80 and 81)

3.17 In 1978, the appellant had the opportunity to purchase a complete set to manufacture the product. He did not buy it because only 70 per cent of raw material was in the end product. It was not economically viable. He felt he could build much better machinery, more sophisticated, and therefore more efficient (SN p 83).

3.18 In 1981, he acquired for $40,000 an instrument with a $400,000 replacement value. In the winter of 1981-82, he acquired for $7,000, a 20-foot trailer of dairy machinery with a $100,000 replacement value. However, no documents were filed to confirm those purchases.

4. Law — Cases at Law — Analysis

4.01 Law

The main provisions of the Income Tax Act involved in this case are 18(1 )(a) and (b) and 248(1), the definition of “Personal or living expenses”. They read as follows:

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;

(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part;

248. (1) In this Act,

“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 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;

4.02 Cases at Law

The following cases at law were referred by counsel for the respondent:

1. — M P Drilling Ltd. v MNR, [1974] CTC 426; 74 DTC 6343; [1976] CTC 58: 76 DTC 6028;

2. — James R Leslie v MNR, [1982] CTC 2233; 82 DTC 1216;

3. Wesley H Warden v MNR, [1981] CTC 2379; 81 DTC 322;

4. William Moldowan v MNR, [1977] CTC 310; 77 DTC 5213;

5. — G Seymour v MNR, [1982] CTC 2683; 82 DTC 1706.

4.03 Analysis

4.03.1 The point at issue concerns the expenses in the 1976 and 1977 taxation years of the proprietorship called Snow Mountain Foods Co. Moreover, it was admitted by counsel for the respondent (SN p 68) that the quantum of the expenses in Snow Mountain Foods Co: $2,346.44 for 1976 and $6,324.26 for 1977 are not in dispute.

4.03.2 The only point at issue is whether the proprietorship Snow Mountain Foods Co. had a “reasonable expectation of profit”. In his submissions, the appellant said: “I submit that de facto . . . there was an expectation of profit in my mind. It was gleaned from observing local manufacturers who worked crudely and in an unsanitary, unsophisticated way, seeing that they were making a profit and knowing that it could be done more efficiently and more profitably than they were doing it. And that was the reason that I endeavoured to find out how to do so. So I think . . . there is . . . a reasonable expectation of profit and I state that I did have such an expectation, I base it on the comparison between the competition and what I knew could be done, using modern practices and modern machinery”. (SN pp 109 and 110)

Moreover, the appellant referred to the M P Drilling Ltd case given by Mr Justice Bastin of the Federal Court of Canada, Trial Division which stated that the definition of “business” in the Act includes an activity preparatory to carrying on business.

The facts in this case are summarized as follows:

The appellant company was incorporated in 1964 for the purpose of marketing liquid petroleum gases. From the date of incorporation to 1966 when the venture was abandoned, substantial amounts were spent in constructing the necessary facilities, conducting negotiations, and generally attempting to put the business in motion. The company eventually decided the scheme lacked feasibility and embarked on a different enterprise which proved profitable. The previous losses were deducted from subsequent taxable income. The Minister disallowed the deductions on the grounds that these were outlays on account of capital.

In its decision, the Court also stated that:

If the marketing plan had succeeded, the profit woudid have been taxable. The same reasoning must be applied to make the loss deductible. Even if a portion of the expenses could be considered to have been incurred in creating a capital asset, the Court ruled that when such a plan proves abortive, the costs of preliminary studies are revenue expenses.

To base its decision the Court referred to:

(a) Mr. Justice Pigeon of the Supreme Court of Canada in the case of Henry J Freud v MNR, [1968] CTC 438; 68 DTC 5279;

(b) Mr Justice Jackett in the case of Canada Starch Company Limited v MNR, [1968] CTC 466; 68 DTC 5320, and,

(c) Mr Justice Noël in the case of Bowater Power Company Ltd v MNR, [1971] CTC 818; 71 DTC 5469.

The Federal Court of Appeal confirmed the decision of Mr Justice Bastin on the basis that the expenditures, being made for the purpose of earning income were not of a capital nature and were, therefore, deductible by virtue of paragraph 12(l)(a) of the Act. Further, the expenses were deductible even though they did not produce any income.

I share the principles in the above cases.

It was even often pointed out by the Courts that the word “reasonable” in the expression “reasonable expectation of profit” qualifies the word “expectation” and not the word “profit”; and, therefore it is not necessary to make a profit in the years involved.

4.03.3 Counsel for the respondent, however, stated that “reasonable expectation of profit” is not synonymous in the appellant’s “intention or hope”. Pursuant to the Supreme Court of Canada it 1s:

. . . 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), 28 DTC 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. (Moldowan case at 77 DTC 5215.)

4.03.4 Can it be said that in the instant case these criteria were met? The evidence is to the effect that since 1970 the appellant was interested in the isolating of protein food product.

However, in the 1976 and 1977 taxation years and even until May 1983, the appellant or his company had nothing to sell. Counsel for the respondent contended that there was no business commencement at all. However, as stated in the M P Drilling Ltd case the definition of business included an activity preparatory to carrying on business.

The only problem in this case is that the important part of the evidence given by the appellant is based on documents of experts which have not been accepted for the reasons given above.

Despite the fact that the Court was well impressed by the appellant’s testimony and the work he did, the Court thinks that he would have had a better chance to see his appeal allowed if the appropriate witnesses would have been heard by the Court.

Once again, the appellant had two years to gather information and to prepare his case. Unfortunately, in the circumstances, the Court must dismiss the appeal.

5. Conclusion

The appeal is dismissed in accordance with the above reasons for judgment.

Appeal dismissed.