Labrèche v. Ministre Du Revenu National, [1999] 3 CTC 594, 99 DTC 5083

Desjardins J.A.:

This appeal from a decision of the Tax Court of Canada concerns the interpretation and application of the concept of “reasonable expectation of profit”, the test used to decide cases concerning the deductibility of business expenses. [1]

The issue to be determined is whether the appellant operated a beauty and tanning salon with a reasonable expectation of profit during the 1987 and 1988 taxation years, the only years before us, in order to be able to deduct the losses incurred in operating this business from his other income.

The Trial Judge dismissed in their entirety the taxpayer’s appeals against the notices of reassessment issued by the Minister of National Revenue, who had refused the deductions claimed.

Facts

On March 19, 1981, the appellant began to operate the business Centre eV Esthétique Deux L.L. Enr. on Lyon Street in Longueuil with his daughter Linda Labrèche. She had completed her studies as a beautician in 1979 and had been working in this capacity in a salon on Gentilly Street in Longueuil for one and a half years. She often discussed her work with her parents. One day, the appellant told his daughter that he had money to invest [2] and asked her if she was interested in opening a business for him, which she would manage. [3] The testimony of the respondent’s investigator responsible for auditing the appellant’s affairs concurs on this point; the taxpayer also told him that the business had been set up as an investment, but that he also wanted to help his children get established. [4]

The appellant and his daughter looked for premises in Longueuil so that his daughter could keep her clientele. Linda Labrèche signed the lease which her father co-signed. They drew up a list of potential income. The appellant was also involved in choosing the equipment. The salon acquired three tanning beds in addition to the equipment required for beauty treatments. Linda Labrèche hired an experienced assistant. The appellant and his daughter advertised in the newspapers and distributed advertising leaflets.

In the summer of 1981, the appellant realized that his beauty and tanning salon, which was located in a shopping centre, was between two restaurants frequented by motorcycle gangs. This serious problem threatened to completely undermine the profitability of his business as the female clientele was liable to be intimidated by these gatherings, especially because the salon was open until nine o’clock at night. They sent letters to the owner, but without success. After bringing legal action against the owner of the premises in June 1983 to break his five-year lease, the appellant decided to start the business all over again. In November 1983, the business moved to the second floor of a building the appellant owned on King George Street in Longueuil. He ran an electronics store on the first floor. The second floor required renovations, however, to meet the needs of the beauty and tanning salon. The appellant’s wife worked there part time as a receptionist. The appellant himself opened the salon in the morning, did odd jobs and closed the business at night, while continuing to do his regular job. According to his daughter, moving and starting over was almost the same as opening two businesses within a few years. [5] The advertising had to be done again.

The business had sales of $55,000 in 1984, $59,377 in 1985, $53,000 in 1986, $63,000 in 1987 and $73,000 in 1988, but the fixed asset costs were high. The tanning beds had to be replaced because they were old and were becoming inefficient. Linda Labréche had to hire casual employees because she had to take time off to look after her children.

Although tanning salons were profitable at the beginning of 1981, they became less so, first because of an increase in the number of this type of business on the South Shore, and later because of new information about a potential cancer risk.

The losses of the business for taxation years 1982 to 1988 were as follows:

1984 47,786

The taxpayer testified that he had given himself five or six years to establish his clientele. In the opinion of the respondent’s investigator, a startup period of three years was normal.

Decision on appeal

The Trial Judge dismissed the taxpayer’s arguments on the basis of the following findings: [6]

[TRANSLATION] The amounts of the annual losses of the beauty salon are not disputed. The evidence did not indicate there was any realistic analysis of income and expenses. Further, while there had been substantial losses in the first year, no changes were made in the following years. I believe the numbers speak for themselves and that a wise businessman would not have continued the business for purely business reasons, especially considering the nature of the business, a beauty salon, the significant losses and the extended period of the venture. There was also a lack of planning and failure to adjust in this business as mentioned in Landry v. The Queen, 94 D.T.C. 6499, at page 6500. I must conclude that the only reasons for continuing the business were family and not business reasons. Consequently, the appellant cannot deduct the losses related to the beauty salon business.

Analysis

Was the Trial Judge justified in stating that [TRANSLATION] “a wise businessman would not have continued the business for purely business reasons...” and in concluding that [TRANSLATION] “the only reasons for continuing the business were family and not business reasons...”?

In my view, she ignored some important aspects of the evidence and incorrectly applied the case law of this Court, albeit some of which postdates her judgment.

Income is taxed according to its source under the Income Tax Act. The amounts to be included in or deducted from the calculation of a taxpayer’s income must come from a source of income recognized in the Act. For the purposes of determining whether there is a source of income, a business is an activity that is profitable or that is carried on with a reasonable expectation of profit.

The factors to consider to objectively determine whether a taxpayer has a reasonable expectation of profit are found principally in Moldowan v. /?., [7] Morrissey v. 7?., [8] and Landry v. R..?. [9] Some of these factors have to do with the period before the start of operations. Examples of this type include the taxpayer’s training and his or her intended course of action, the capability of the venture to show a profit after charging capital cost allowance, the absence or presence of planning, and the absence or presence of the necessary ingredients for profits ultimately to be earned.

Other factors can be observed as operations are carried on. The following are bench marks for objectively assessing whether to allow or disallow an expense for tax purposes: the number of consecutive years during which losses were incurred, the time required to make the activity profitable, the time devoted by the taxpayer to his or her business, the profit and loss situation for the years subsequent to the years in issue, the reasons behind the increase in expenses and decrease in income in the course of the relevant periods, the persistence of factors causing the losses, and the presence or absence of adjustment.

This list is not exhaustive however. The factors differ with the nature and extent of the undertaking. [10]

In Tonn v. J?., [11] this Court recognized that common sense should prevail and that it was not for the courts to review, with the benefit of hindsight, the business judgment of a taxpayer whose business turned out to be less profitable than expected. [12] . There should be a grace period for emerging operations. In Watt v. Z?., [13] this Court stated that a personal element may coexist with a profit motive. If that is the case, the existence of the personal element will prompt the Court to apply the reasonable expectation of profit test more assiduously. Where the personal element is “the dominant, motivating force”, the taxpayer’s burden must be considerably more onerous.

The principal factors the Trial Judge considered in assessing how reasonable the appellant’s losses were included the lack of a realistic analysis of income and expenses, the failure to adjust following the substantial losses in the first year, and a personal element: the taxpayer’s desire to help his daughter get established. She did not, however, take other factors into account, including the unforeseen difficulties caused by the relocation of the business in 1983 and the start-up period required for all businesses of this type. Furthermore, a responsible parent’s concern for getting his or her child established remains an acceptable consideration for the purposes of taxation if, apart from family considerations, there is also a clear goal that the business will be profitable. The Trial Judge gave this personal element far too much importance without sufficiently considering the evidence, especially the fact that the taxpayer also wanted to start a profitable business. As previously mentioned, the respondent’s investigator fully corroborated the testimony of the appellant and his daughter.

The Trial Judge was certainly justified in observing that the analysis of the income and expenses at the beginning of operations was rudimentary. However, she had to consider what the taxpayer had to deal with from the beginning of the business, namely the unforeseen difficulties due to the presence of motorcycle gang members near his first location. The relocation to different premises required further expenditures. In the case at bar, the three to five or six year start-up period to which the appellant is entitled must also be calculated from the relocation to the new premises in the fall of 1983, not from 1981 when the first salon was opened. Consequently, it is difficult to conclude, as the Trial Judge did, that a wise businessman would have closed his doors sooner. To this, I can only cite the words of Mr. Justice Linden of this Court in Tonn v. R.:14 [14]

It is not for the Department (or the Court) to penalize them for this [error], using the reasonable expectation of profit test, without giving the enterprise a reasonable length of time to prove itself capable of yielding profits.

In view of all of these factors, I would allow this appeal with costs here and below, set aside the judgment of the Tax Court of Canada and refer the matter back to the Minister of National Revenue to issue reassessments for 1987 and 1988 allowing the deduction of the appellant’s losses.

Appeal allowed.