Rempel v. R., [1997] 2 CTC 3002

Teskey T.CJ.:

The Appellant appeals her reassessment of income tax for the years 1990, 1991, 1992 and 1993. She elected to have the informal procedure apply.

Issue

The sole issue before me is whether an Amway operation, in which the Appellant was connected with, was a business.

Facts

The Appellant in her T1 tax return for the years in question claims as a sole proprietor losses for the Amway operation in the amounts of $8,955, $33,028, $20,446 and $15,913.

All figures herein have been rounded to the nearest dollar.

From the evidence before me, there is no doubt that the Amway operation was a joint venture between the Appellant and her husband. All cheques from Amway were payable to both of them.

They each devoted approximately equal time on the enterprise and had their own separate areas devoted to it. The husband said “I was the main leader in the whole organization!”. The Appellant and her husband will be collectively referred to as the partnership. I find that it was a joint enterprise and they were equal partners.

The partnership decided that the enterprise would produce income by developing three separate sales forces operating under them. The income would arise from the volume bonuses Amway would pay to them. Product was purchased by the partnership and sent to their sales forces at the same wholesale cost. The volume bonuses would have to be high enough to cover all costs in order to produce a profit.

The gross sale volume bonus was as follows:

The partnership’s separate sales forces were to be in Dauphin, Churchill, Rainy River and Winnipeg.

Thus if each cell had sales as per diagram in a month:

[Graphic not reproduced. I

Therefor, the partnership would have $11,000 sales for the month. The bonus would be ($11,000 x 21% = $2,310) $2,310.

From this, the partnership would have to pay the following amounts as bonuses:

Then the Appellant would earn on the bonus percentage ($2,310 - $1,650 = $660) $660.

There was also an extra profit bonus of $10,000 at the year end. To qualify for this, a sales cell, or one leg, had to have sales of $15,000 each and every month of the year, so that even if all of the sales cells or legs that the Appellant had totalled $15,000 each and every month this bonus would not be earned. Also, if one cell had six months sales of $20,000 a month and six months sale at $10,000 a month, for an average of $15,000, a month, the bonus would not be raised. I am not satisfied that the partnership would ever attain this extra profit bonus.

The only figures reduced to writing is Exhibit A-2 attached hereto and under the heading “Schedule A”. Schedule A was prepared by a certified accountant from the Appellant’s T1 tax returns for 1989, 1990, 1991 and from records for years 1992 or 1993. No effort was made to substantiate the amounts in any way. Although these are all I have to work from, I must say that they are grossly suspect and I do not believe they are accounts for these reasons:

1. The Appellant stated that retail sales were made each year. Exhibit

A-2 does not show any retail sales in years 1989, 1990 or 1991.

2. The Appellant said that they used between $100 or $200 of Amway products personally a month. The yearly amount would then be a low of $1,200 to a high of $2,400, yet the cost of sales for 1989, 1990 and 1991 is identical to wholesale direct shipment sales.

3. Under the heading sales, the performance bonus is entered.

4. Also shown are sales aids under both Sales and Cost of Sales. These figures are identical each year. This cannot do anything but produce a loss.

5. Also in Expenses, GST appears only in 1991 and also in that year large amounts appear for office supplies and office shelving. Undoubtedly, the latter and most of the former should have been capitalized.

6. In 1992 and 1993, the Appellant purported to pay her husband

wages notwithstanding reduced sales and substantial losses.

The bonuses when separated out look as follows:

Dealing with their own recorded retail or wholesale sales in summary, they look like this:

These figures were never explained and cannot be accurate in light of the fact that from wholesale to retail, there is a 30% mark up unless there is shrinkage in 1993 or the $4,000 figure is fictitious.

Thus, in the years before me, taking the gross profit from the bonus income as all other income was shown as a straight set off against the claimed expenses, the figures are:

The husband stated that his goal for year end 1989 was to have three cells or organization each selling $5,000 per month. Having only Exhibit A- 2 in front of me, I cannot tell if this was obtained. However, if it was, and was held through 1990, the gross sales would have been ($5,000 x 3 x 12 = $180,000) $180,000. The gross sales were $87,248. Thus the target of $180,000 of sales for 1990 was short by ($180,000 - $87,248 = $92,752) $92,752.

It was also stated that they felt they would make a profit after three years. They figured it would take three years to build up their three separate sales entities, (that is Rainy River, Dauphin and Churchill) each producing sufficient sales, that there would be a net profit after expenses. In light of the history of this enterprise, this goal was fantasy and could never be obtained.

Undoubtedly, the car accident that John Gibbons, the Rainy River sales force leader was in, (that left him incapacitated) was a large set back and increased the 1991 travel expenses. However, the sales force was still there in Rainy River.

When you compare the increase in travel expenses for 1991 over 1990, the total increase in expenses is in the area of only $5,751.

When you deduct the decrease shown under the heading “Travel” in the amount of ($3,459 - $942 = $2,517) $2,517, the total increase in expenses that can relate to the loss of Gibbons in Rainy River amounts to ($5,751 - $2,517 = $3,234) $3,234. Yet, the Appellant claimed that her expenses went from $17,097 in 1990 to $31,300 in 1991, an increase of $14,203, when only $3,234 can be attributed to the incapacity of Gibbons.

In 1992 and 1993, the Appellant and her husband spent most of the year in Churchill and now reside permanently there. Churchill, Manitoba, is approximately 1000 km north-east of Winnipeg and is only accessible by air or rail. The partnership is still involved with Amway. No financial statements or figures were presented to the Court for the years 1994, 1995 and 1996. The only comment made was to the effect that “Tax not done since 1993”.

Analysis

The Appellant argues that since there is no personal element in the Amway enterprise, thus I ought not to second guess the Appellant in hindsight and that the expenses should be allowed. The Appellant referred me to Tonn v. R. (1995), 96 D.T.C. 6001 (Fed. C.A.) as authority for this.

Linden, J.A. said in Tonn (supra):

The scheme adopted by the Income Tax Act taxes income according to source ... Four such sources are contemplated: income from employment, business, property and capital gains income.

Various expense deductions are provided in the applicable rules for each of the above four sources. The deduction rules for the property and business income sources are found substantially in sections 9 and 18 through 21.

Among other things, well accepted principles of business suggest that only expenses incurred as relevant and working expenses of some process of income earning are deductible. Those which bear no relation to the income earning process, and those which are of a personal nature, are not. Since the pursuit of business income is founded on the intention to earn profit, subsection 9(1) incorporates as a test for deductibility the intention to make profit.

... Lo be deductible according to paragraph 18(1)(«), an expense must have been incurred with the intention of producing profit. In other words, the expense must have been incurred within a business framework, bearing some relation to the income earning process. I might mention in this context that such intention, strictly speaking, is subjective; no requirement of objective reasonability is expressly imposed by the section.

As Dickson, C.J. wrote in Bronfman Trust v. The Queen, [1987] 1 S.C.R. 32, at page 46:

The interest deduction provision requires not only a characterization of the use of the borrowed funds, but also a characterization of “purpose”. Eligibility for deduction is contingent on the use of borrowed money for the purpose of earning income.

The Moldowan Test

Dickson, J. said in Moldowan v. The Queen, [1987] 1 S.C.R. 480, at page 485:

Although originally disputed, it is now accepted that in order to have a “source of income” the taxpayer must have a profit or a reasonable expectation of profit. Source of income, thus, is an equivalent term to business.

...I am satisfied, therefore, that the scope originally contemplated for the Moldowan test by Dickson, J. was broader than that suggested by paragraph

... he Moldowan test is stricter than the business purpose tests set out in subsection 9(1) and paragraph 18(1)(a). As mentioned above, these tests stipulate that a taxpayer be subjectively motivated by profit when incurring an expenditure. The Moldowan test, however, also requires the presence of a profit motive, but, in addition, it must be objectively reasonable. In reality, in most situations, the objective Moldowan test and the subjective statutory tests will not yield many different results. A subjective intention is often determined by what may be reasonably inferred from the circumstances. Someone who claims a subjective intention that is foolish may not be believed. A taxpayer’s intention to produce profit normally has to be reasonable before a Court will accept it.

lacobucci, J. said in Symes v. Canada, [1993] 4 S.C.R. 695, at page 736:

...Courts will, instead, look for objective manifestations of purpose, and purpose is ultimately a question of fact to be decided with due regard for all of the circumstances.

...transactions contrary to the purposes of the Act are generally those where the underlying aim is inappropriate tax avoidance. The attempt to deduct the costs of what are essentially hobby or personal expenses as a business expense is one good example.

...the Moldowan test is ideally suited to situations where a taxpayer is attempting to avoid tax liability by an inappropriate structuring of his or her affairs.

But do the Acf s purposes suggest that the deductions of losses from bona fide businesses be disallowed solely because the taxpayer made a bad judgment call? I do not think so.

...that for most cases where the department desires to challenge the reasonableness of a taxpayer’s transactions, they need simply refer to section 67. This section provides that an expense may be deducted only to the extent that it is reasonable in the circumstances.

Bowman, T.C.C.J., in Cipollone v. The Queen, [1994] E.T.CV. 405, at page 408:

The reason her losses were as great as they were was not because the business had no reasonable expectation of profit or because she was not expending money for the purpose of gaining or producing income from a business. I find as a fact that she was spending money in order to earn a profit and that her expectation of earning a profit was reasonable, if she had chosen to claim reasonable expenses. The problem lies not in the absence of a reasonable expectation of profit - businesses of this sort can be quite lucrative -- but rather in the attempt to deduct unreasonable expenses.

The Moldowan test, therefore is a useful tool by which the tax-inappropriateness of an activity may be reasonably inferred when other, more direct forms of evidence are lacking. Consequently, when the circumstances do not admit of any suspicion that a business loss was made for a personal or non-business motive, the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgment may have been less than competent.

The Case Law

… The cases in which the “reasonable expectation of profit” test is employed can be placed into two groups. One group is comprised of the cases where the impugned activity has a strong personal element. These are the personal benefit and hobby type cases where a taxpayer has invested money into an activity from which that taxpayer derives personal satisfaction or psychological benefit. Such activities have included horse farms, Hawaii and Florida condominium rentals, ski chalet rentals, yacht operations, dog kennel operations, and so forth.... Any desire for profit in such contexts is no more than a “pious wish” or “fanciful dream”.... What is really going on here is that the taxpayer is seeking a tax subsidy by deducting the cost of what, in reality, is a personal expenditure.

The other group of cases consists of situations where the taxpayer’s motive for the activity lacks any element of personal benefit, and where the activity cannot be classified as a hobby. The activity, in these cases, seems to be operated in a commercial fashion and not as a veiled form of personal recreation.

...the Court may decide that, though the taxpayer genuinely intended the pursuit of profit through a purely commercial activity, the intention was unrealistic, the expectation of profit unreasonable, and hence, the activity was not a business.

...where the activity is purely commercial, they rarely are challenged. If they are, the Courts have been reluctant to second-guess the taxpayers, with the benefit of the doubt being given to them.

the Moldowan test should be applied sparingly where a taxpayer’s “business judgment” is involved, where no personal element is in evidence, and where the extent of the deductions claimed are not on their face questionable.

...a detailed look at the business in the context of operations is what is required, and that reasonableness is to be assessed on the basis of all the relevant factors, both the already listed ones and any new ones that may be helpful.

It was a residential property purchased for commercial purposes.

Another factor to consider is the “time required to make an activity ... profitable”... The jurisprudence has long accepted that during the start-up phase of a business, courts will be lenient in applying the Moldowan test. The leniency is only fitting, for start-up is a time when uncertainty is necessarily great, and when businesses generally sustain the heaviest losses. Due to these reasons, several years may pass before one can tell whether a business will be profitable. The Courts have recognized this by allowing what is in effect a grace period for emerging operations.

These considerations apply equally to a rental operation.

A further matter worthy of mention is that real estate, like shares, may be purchased not only to create an income stream but with an eye to an eventual capital gain... One reason why real estate and securities alike present good investment possibilities is that they offer the possibility both of earning income and of obtaining capital gains in the future.

Linden, J.A. in Corbett v. The Queen, released October 30, 1996, said:

In applying Moldowan, it is not whether profit is earned, but whether it could reasonably be earned. As long as the business has a reasonable chance of earning profit in the year or in the near future, the interest is deductible, whether or not there actually was a profit earned in a given taxation year. That is the lesson of the Tonn case, which only seeks to restate and clarify the application of the principle of Moldowan. Thus, where as here, if no profit is possible in the year or in the near future, no deduction can be allowed (at least as long as Moldowan continues to govern cases such as these).

In this case, the stated goal was annual sales of $180,000. The partnership was some $93,000 in 1990 short of this goal, and some $110,000 short in 1991 and $178,000 short in 1992 and $139,500 short in 1993. Both sales and gross profit before expenses declined each year after 1990.

I am satisfied that in this Amway enterprise, there is a small portion of personal benefit attached to it. It falls between the typical personal benefit cases where a taxpayer purchases a duplex and occupies one unit and rents the other and where the taxpayer purchases a single unit property with no intention of ever occupying the property personally or renting it to a nonarm’s length tenant.

The Amway enterprise herein is operated out of their own personal residence, using their personal motor vehicles and telephone. Between the Appellant and her husband, they each had relatives in Dauphin and Churchill and a connection to Rainy River. Thus trips to Dauphin and Churchill had a personal element.

Since no figures were produced for 1994, 1995 and 1996, I can only assume that the partnership continued to experience losses in the Amway enterprise. Under this factual situation, I do not believe that Tonn is of assistance to the Appellant.

I am not convinced the partnership could reasonably have been expected to produce a profit in 1990 nor in the near future thereof. In the four years in question, the claimed losses totalled approximately $76,500 and undoubtedly losses continued on in 1994, 1995 and 1996.

Obviously, it is up to the Appellant to demonstrate that the Amway enterprise would produce a profit within a reasonable period of time. She has failed to do so.

The appeal is dismissed.

Appeal dismissed