Johnston v. R., [1998] 4 CTC 2437

Bell T.C.J.:

Issues:

The issues in this appeal, as stated in the Notice of Appeal and Reply to the Notice of Appeal are:

(a) whether the Appellant had a reasonable expectation of profit from certain activities carried on by him in the 1991 and 1992 taxation years, and

(b) whether the expenses incurred and claimed by the Appellant were incurred for the purpose of gaining or producing income from a business within the meaning of paragraph 18( 1 (a) of the Income Tax Act (‘'Act").

Although the Reply to the Notice of Appeal posed a question as to whether, in the alternative, the expenses claimed were reasonable in the circumstances, no submission was made by Respondent’s counsel in that regard and, accordingly, will not be considered in these Reasons.

Facts:

The Appellant described himself as a “business principal”. He completed high school and two years at York University, leaving because he wanted to commence business. While a student, he purchased inoperative cars and repaired and sold them. In summers, he was involved with swimming pool installation and construction. After school, his first business was a chemical cleaning products distribution. Before his marriage, he picked up bundles of Toronto Star newspapers in a van and delivered them to street comers for delivery.

His view of the results of the oil crisis in 1974 and subsequent years led him to believe that well-off people would be moving from the cottage country to areas such as Caledon Hills where he had grown up. He planned to build and maintain swimming pools. For personal reasons this business was never commenced. He then bought a distributorship for chemical cleaners to be sold on a door-to-door basis so that his wife, he having married in 1976, could also participate and earn income. He stated that he could do this on a part-time basis, his full-time employment at that time being with the post office.

In 1978, he founded Custom Design Installation Ltd. (“Custom”). It delivered and installed office furniture. It took several years for the business to develop. The Appellant testified that steady pay cheques for him and his wife were first received in 1981. By 1988 Custom had 20 full-time installers working for it and the company had gross revenue of between $1.2 million and $1.3 million.

The Appellant was deeply affected by the death of his father in 1984 and realized that he should change his seven days per week working habit. He took his first vacation in nine years, going to the Bahamas on a yacht trip. In 1985 he took a one week vacation to the Caribbean and again went on a charter boat on a “day sail”. He repeated this experience in 1986 in Antigua.

After consulting with Clarkson Gordon respecting his decision not to work as intensely and after a period of approaching and interviewing different persons, he sold 50 percent of his company to a Mr. Love whose ambitions respecting the business were like those of the Appellant, namely to work at same until his retirement.

The Appellant was always looking for business opportunities. Particularly, he was observing how the yacht people ran their operations. He noted that they seemed to have a line-up of people and that he and his wife had to wait several days for a booking.

He was also looking at fixing cars and selling them on a sophisticated level after restoration and to that end purchased a property with a three bay heated garage. He has not yet commenced that business. He was interested in cars and boats. As a child, his father had a hobby farm where he said he learned how to fix tractors and equipment and learned about hard work. He said that he gravitated towards fixing things. He also said that he worked closely with his chartered accountant at Clarkson Gordon, that he had no business training, and that when he had ideas or received information interesting to him he would talk to his accountant. That firm was preparing a prospectus for Bimini, a charter company in the Virgin Islands doing what the Appellant wanted to do. Clarkson Gordon, he said, was quite informed about these operations.

A large number of exhibits were filed with the Court, obviously intended to demonstrate that the Appellant was serious about commencing a yacht charter operation as well as the experiences and difficulties he had after the commencement of same. There were 25 such exhibits, ranging from rate schedules for yacht charters for Bimini, invoices from Clarkson Gordon in 1987 and 1988 with respect to consultations connected with that type of business, other information on charter rates and a number of different hand-written notes comprising about 14 pages on how different charter ventures operated. They summarized the computation of transactions, and reported on conversations with persons experienced in the businesses and attendances at the Toronto boat show, et cetera. He was impressed with the weather in the Virgin Islands where he first went in 1987, they, according to him, being beautiful islands with a year round temperature of 75 to 80 degrees Fahrenheit. On return to Toronto, he called the British Virgin Islands’ Minister of Tourism and Industry and met with him in Toronto at the Toronto boat show. The British Virgin Islands (“BVI”) had a booth at that show. Yacht charter companies were also represented at the show, all based in the Virgin Islands, most in the BVI. The Minister steered him to the appropriate yacht management companies and he had discussions with them. He said that he was “looking at how” to make money and what kind of investment would produce that result. He collected a number of “hand outs” at the boat show, took them to Clarkson Gordon and asked them to review them. In November, 1987, he went to the Virgin Islands to do a close-up examination of the yacht business, having made appointments for that purpose. He wanted to see the facilities and to analyze whom he thought would be the best group with which to do business. He was impressed with Tropic Island Yacht Management (“Tropic Island”) which had well maintained used boats that were docked in the middle of a city. He said the location was important because of the ability to obtain provisions nearby for charter parties. There was also a hotel there together with first class facilities. He had met Rolf Steinhueble (“Rolf”), the owner of Tropic Island at the Toronto boat show. He obtained copies of contracts and rate schedules. He was advised by Rolf that he would accept a used boat in his fleet. They discussed the types of boats that would be acceptable.

The Appellant had the rate schedule for a Whitby 42. He prepared estimates of what revenue he could expect based upon the number of weeks per year when the operation could be conducted. He received different proposals from various companies as to the percentage of revenue that could be retained. He finally decided to purchase a Whitby 42. He started looking in Toronto and then outside the city because there were, in his words, “quite a few such boats in the Great Lakes area”. He did not find one in Ontario. The next closest market according to the Appellant was the eastern United States. He found prospects in Annapolis, Maryland, in the Chesapeake Bay area, being prime chartering grounds. He contacted a broker who found a Whitby 42 to his satisfaction. This boat was named ORION. The Appellant said that it looked like it had never sailed, that it had been owned by a fastidious gentleman and that it had little use over its six seasons. He described it as being in perfect condition. He obtained all the specifications of this boat and engaged the services of Manning Marine Survey to prepare a survey report of the boat. That report consisted of nine and one-half pages. It concluded with the statement that,

This vessel is generally well built using good materials and acceptable methods. She also appears to have been fairly well maintained, and is currently in need of relatively few corrections and repairs as reported.

The conclusion also stated that an appraisal of current market value was $110,000 whereas the estimate of replacement would be $180,000. The Appellant took photographs of the boat and with this report, flew to Tortola and was advised by Rolf that he would accept the boat. The Appellant then returned to Annapolis, made an offer on the boat, and purchased same for $105,000 U.S. This was paid by a down payment of $15,000 Canadian and a bank loan for the balance of $125,000 with the boat being given as collateral. Other documents show the engagement of the services of Seven Seas Yacht Deliveries to take the boat to BVI. The boat arrived at that destination. The August 18, 1988 contract for charter management with Tropic Island and a credit note of January 4, 1989 respecting the first charter fee were filed as exhibits.

The Appellant’s testimony was that he had a number of problems with Tropic Island. He said that a lot of unnecessary work was done on the boat, that he had been billed for work which was not done, that he had been double billed for some work and that the company was not generating charters as promised.

On visiting the BVI the Appellant learned that Tropic Island was moving from Rhodetown, the hub, to a marina facility in a remote location. It had been abandoned by a bankrupt yacht charter company. He said that this needed repair and that there was no facility for provisions. The relationship with Rolf deteriorated quickly.

He obtained a new marine survey in June, 1989 for insurance purposes. On August 18, 1989, the Appellant received two letters from James C. Hall, a man said to be experienced in the travel business recommending an “honest and trustworthy charter operator in the Caribbean”. He entered into a charter management agreement with that company (“Tortola”) in September, 1989, the first charter voyage to be made in November of that year. This association also proved to be unsatisfactory. The Appellant said that he was with Tortola for about two and one-half years and that the experience was like that with Tropic Island but with a bit more charter activity. He said the repair bills were the same or worse, that business was not great for that company and that it sought to earn its money with unnecessary repairs to his craft. He also stated that a hurricane in 1988 affected business and that another hurricane in 1989 devastated the Virgin Islands. He went to the islands to assess the damage and stated that yachts were strewn up the hillside over 100 feet, that a number were sunk and facilities had simply been wiped out. He said that he reached the point where he told Tortola to cease repairs unless he was advised and given estimates in advance. He said that he learned that his boat was used to take hotel guests out on one day charters and that he received his share of only one trip. He said also that a letter of July 10, 1990 advised that costs were escalating and that the mechanical fees would be increased as would fees for boat watching, advertising, storage lockers, insurance and owner’s use. He also spoke of a terrorist bombing over Scotland affecting air traffic to the Virgin Islands adversely. Appellant’s counsel also filed as an exhibit a facsimile message recommending someone who could manage the boat. That was not pursued.

The Appellant also gave evidence on how he had tried to cut expenses, among other things, moving the boat to Nanny Cay, a not nice but inexpensive dock space. He also decided not to use bare boat charters anymore but to “crew charter” which he opined would result in less damage to the boat.

He became involved with a gentleman by the name of Billy Flynn (“Flynn”) who was to help him look after the boat and find charters. None resulted.

The Appellant then, describing these disappointments, said that he explored the Toronto market and decided to return to that city. He said that after two months of homework he found a crew to bring the boat to Toronto. He went to BVI to see the boat off, the principal crew member having papers for celestial navigation. He made many repairs to the boat himself, the people he had engaged to do same having done little or nothing. He purchased a Global Positioning System (“GPS”). However, the crew had not taken enough batteries to use it. The boat left in the first week of October, 1992 but the crew got lost. The Appellant stated that due to panic and fatigue the boat was run into a reef in Bermuda. He was advised that there was not a great deal of damage but that proved not to be the case. He received a telephone call from a marine facility in Bermuda saying that the boat needed a lot of work and he consequently went to Bermuda. He recovered his GPS and had the skipper removed from the island. The boat laid over in Bermuda until July, 1993. He assembled a new crew of competent people and they arrived in Toronto. He said that most of the repair work done in Bermuda was faulty, that all systems failed between Bermuda and the U.S.A., that the boat was sinking and that the U.S. Coast Guard saved them. In Toronto the boat was taken to Pickering, where it stayed for two years, to a boat repair facility selected by the insurance company. The Appellant testified that he was involved in other activities and so the boat sat another year - until 1997. It was then taken to Bluffer’s Park Marina for more repairs. He said that his plan is to put it in the charter business with a crew from there. On cross-examination, it was established that little or no capital cost allowance on the boat had been claimed.

Whereas the Appellant stated that he thought the interest rate at the bank was approximately 10 '/s percent, Respondent’s counsel suggested that the amount was at least 13 percent. There was no satisfactory evidence to establish the actual rate. The Appellant said that he had documents with respect to the bank loan but that his wife had control of that file and that she, for purposes of divorce proceedings, had taken some of the documents to her lawyer and that this material disappeared. His divorce was finalized in 1993. Respondent’s counsel also asked questions with regard to the number of times the Appellant’s wife accompanied him to BVI. This culminated in the Appellant’s statement that the expenses of those journeys were deducted by the company. He also said that they stayed on the boat as opposed to staying in an expensive hotel.

It was established that losses and relevant figures were as follows:

The Appellant was also asked questions, on cross-examination on two occasions, respecting why he did not get rid of the boat.

Appellant’s counsel read into the record extracts from the examination for discovery of Joseph Florentino, business auditor with the Department of National Revenue as follows:

54. Q. In the Minister’s assumptions that are in the reply -- I would like to take you through those items. In 15(a) when the reply says that the appellant had no training in the activity, was that as assumption as at say 1987 or 1988 or was that an assumption applied to 1991?

A. At the beginning when he commenced the charter operation.

55. Q. 15(b), did you have any information that he had any other businesses other than Custom Design Installation Limited and the yacht charter business?

A. No. No.

56. Q. 15(c), says that the appellant prepared no business plan to determine if it would be profitable. Now, today your counsel went through in some detail the -- a folio of handwritten notes that Mr. Johnson (sic) produced and, indeed, his explanation. Did you see that material when you did your audit?

A. No, I did not.

57. Q. Today was the first time you had seen that material?

A. Yes.

58. Q. The figures that are in paragraph 15(d) follow the figures that are in the tax returns. Are we agreeable, Mr. Ghan, that the receipts and the amounts of the expenses are not for the purpose of this trial in dispute and have to be individually proved? We can just get on with the legal point?

MR. GHAN: I don’t think so. We are contesting --

THE DEPONENT: No, we’re not contesting on that.

Analysis and Conclusion:

Moldovan v. R. (1977), 77 D.T.C. 5213 (S.C.C.), is almost always cited in reasonable expectation of profit cases, no matter what fact situation exists. In that case, Dickson, J., in discussing the question of whether the Appellant’s chief source of income was neither farming nor a combination of farming and some other source of income,[1] said, at 5215,

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.

The word “business” is defined in Section 248 of the Act as follows:

“business” includes a profession, calling, trade, manufacture or undertaking of any kind whatever and, except for the purposes of paragraph 18(2)(c), section 54.2 and paragraph 110.6( 14)(), an adventure or concern in a nature of trade but does not include an office or employment.

The seemingly endless parade of reasonable expectation of profit cases has advanced with little, if any, attention paid to this definition of business. It is pointed out that the question in many other cases, and in the case at bar does not involve the determination of whether there was a source of income. In those other cases there was, and in this case there is, a business. One wonders whether the life of the concept of “reasonable expectation of profit”, spawned and nourished by the quest to determine the existence or non-existence of a source of income, should have faltered in the face of what was unquestionably a “business”. The facts in this case establish, clearly, that the Appellant was involved in an “undertaking of any kind whatever” and certainly in an “adventure or concern in the nature of trade”. This seems, in a number of cases, not to have been brought to the attention of the Courts. It certainly has not been discussed in what are described as major decisions in the world of reasonable expectation of profit. Indeed, the jurisprudence seems to have leap-frogged from its “source of income” origins to become the matrix of deductibility of business expenses.

In the words of Linden, J.A. at page 6006 of Tonn v. R. (1995), 96 D.T.C. 6001 (Fed. C.A.) , with respect to the Moldowan quotation above:

These words, well known to practitioners and departmental personnel alike, have become the first and often last resort for most cases involving the question of business expense deductibility. The words “reasonable expectation of profit” have assumed the status of a benchmark test by which questions of business expense deductibility are normally determined.

The learned Justice’s discussion of the issue of the origin of the reasonable expectation of profit test dealt with the “source of income” and it constituting a test stricter than the business purpose test set out in subsection 9(1) and paragraph 18(1)(a) of the Act. He stated at 6008 that the test requires the presence of a profit motive and must be objectively reasonable. In the face of a number of decisions which have literally exhausted the discussion possibilities of “reasonable expectation of profit” I have no intention of seeking to challenge the foundation supporting that belaboured sculpture. Given the fact that I am literally instructed by jurisprudence to apply that test even where there is no doubt about the evidence of a legitimate business I will refer to certain segments of the Reasons for Judgment of Linden, J.A. in Tonn. At 6009 Linden, J.A. said:

I have dwelt upon the issue of the origin of the “reasonable expectation of profit” test because a proper understanding of it is necessary to the resolution of this application. As a common law formulation respecting the purposes of the Act, 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. One such situation is the attempted deduction of an expense incurred to gain a tax refund. Another is an attempt by a taxpayer to deduct personal housing expenses under the guise of a free-lance typing business operated by his wife. These cases are merely instances where an inappropriate use of the Act is attempted, and where the Moldowan test has rightly denied deductibility on the basis that the Act’s purposes would otherwise be violated.

But do the Act’s purposes suggest that deductions of losses from bona fide businesses be disallowed solely because the taxpayer made a bad judgment call? I do not think so. The tax system has every interest in investigating the bona fides of a taxpayer’s dealings in certain situations, but it should not discourage, or penalize, honest but erroneous business decisions. The tax system does not tax on the basis of a taxpayer’s business acumen, with deductions extended to the wise and withheld from the foolish. Rather, the Act taxes on the basis of the economic situation of the taxpayer - as it is in fact, and not as it should be, subject to what is said below.

The Moldovan 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.

I do not intend the use of those latter words to apply to the present Appellant. At page 6012, Linden, J.A. said:

The primary use of Moldovan as an objective test, therefore, is the prevention of inappropriate reductions in tax; it is not intended as a vehicle for the wholesale judicial second-guessing of business judgments. A note of caution must be sounded for instances where the test is applied to commercial operations. Errors in business judgment, unless the Act stipulates otherwise, do not prohibit one from claiming deductions for losses arising from those errors.

He then cites an author and two cases which reinforce that view.

The Appellant was a wholly credible witness. I accept his evidence. He has been and is an entrepreneur who believes in instituting business enterprises and pursuing them or abandoning them in the absence of a conviction that they will succeed. The evidence supports this entrepreneurial spirit and activity. It points clearly to his success in establishing and continuing Custom.

It is hard to imagine that he could have done more to ensure not only a reasonable but a thorough examination of the yacht business he was seeking to enter. The evidence is clear that he consulted with experts with respect to the boat and with respect to the type of operation and with respect to other matters where he turned to experience for assistance. It does not militate against his business acumen that he encountered difficulties in an environment where it appears that not only were business ethics ignored but fraud was practiced. He encountered problems both from man and from nature which could not be foreseen. It might be said that he was extremely unfortunate with regard to a number of the events described above. However, it is clear to me that this man set out in the yacht charter business with the purpose of succeeding in turning it to account in an economic way. The Reply to the Notice of Appeal stated that the Appellant, before starting the “Activity ... prepared no business plan to determine if it would be profitable.” That is clearly incorrect as palpably demonstrated by the Appellant’s evidence and the admissions of the tax department’s auditor.

Linden, J. says that the test should be used sparingly and with a latitude favouring the taxpayer, whose judgment may have been less than competent. His reasons in Tonn allow for honest but erroneous business decisions. I do not, in this case, find that the Appellant made erroneous business decisions. I do not find his judgment to have been less than competent.

Linden, J. also said that errors in business judgment do not prohibit one from claiming deductions for losses arising from those errors. It seems clear that he meant the deduction was not prohibited, not simply that claiming deductions was not prohibited.

It is my perception that the Appellant tried to make this business work, even in the face of adversity. He finally decided (and this was a business decision) to move the operation to Canada. The fact of the catastrophic events in Bermuda and on the journey between Bermuda, after a lengthy reparation, and the United States of America, were totally beyond his control. He now plans to recommence his operation in Canada and will, undoubtedly, use the experience he has gained to this date.

It is not the place of the tax department to suggest that a businessman should cease his activity. That is the businessman’s prerogative in an entrepreneurial and free society. If he fails for some reason which is unrelated to his earnest endeavours, that should not necessarily compromise his ability to deduct losses. It is axiomatic that an individual, even with expert opinions in advance that he or she had no reasonable expectation of profit and who made profits in the first year of an enterprise, would be taxed on same. Assume that he or she could adduce evidence from Masters of Business Administration, Chief Executive Officers of corporations, accountants knowledgeable in business, et cetera, that would establish beyond doubt that no reasonable expectation of profit existed. That taxpayer would have little success arguing with the tax collector that he should not be taxed because he had no “reasonable expectation of profit”. And so courses that one way street.

In the circumstances, I have no hesitation in concluding that the Appellant had commenced a business with the intention and expectation of realiz ing a profit. Given all of the surveys he had commissioned and steps he had undertaken, which continued in the years under appeal, that expectation was reasonable. It is not the place of the tax collector or the Court to comment on what business steps he should have taken. My conclusion is based upon what he did, not what he could have done.

I find, not only that the Appellant had a reasonable expectation of profit but that the expenses incurred and claimed by him are properly deductible with the meaning of paragraph 18(1)(a) of the Act as having been incurred for the purpose of gaining or producing income with the result that the claimed losses are deductible.

Accordingly, the appeal is allowed with costs.

Signed at Ottawa, Canada this 31st day of July, 1998.

Appeal allowed.