Date: 19980206
Docket: 96-1262(IT)I
BETWEEN:
RYAN H. McNALLY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Rowe, D.J.T.C.C.
[1] The appellant appeals from an
assessment of income tax for his 1993 and 1994 taxation years.
The Minister of National Revenue (the "Minister")
disallowed business losses in those years in the sums of $34,003
and $27,983, respectively, claimed by the appellant as having
been incurred as a consequence of operating a business under the
name, "McNally's German Wirehair Pointers".
[2] The appellant testified he lives
at Calahoo, Alberta and is employed, full time, as an engineer
with Canadian National Railways (CN). He stated he was living in
Morinville, Alberta, in 1989, when he began purchasing
German Wirehair Pointers. During that year and following, in
1990, he purchased a total of three dogs, two females and one
male. At that time, he was living in a house in a subdivision and
he began receiving complaints from his neighbours concerning the
dogs. In 1991, he found an 80-acre parcel near Calahoo, in the
County of Sturgeon, within a one-half hour drive from Edmonton,
where the land-use regulations permitted the discharge of
firearms, which is required in the course of training his dogs.
The parcel was raw land and he took up residence there by living
on the land in a truck and camper. He had telephone service
brought to the property and he cleared land in order to built a
36-foot by 24-foot shop with runs and kennels for the
dogs. He also drilled a well for a water supply. During this
period, he was working full time and was absent from the property
for 12 hours at a time. The appellant explained he had been born
in Northern Ontario and had grown up with hunting dogs. During
his childhood and teenage years, he had raised beagles and
Springer spaniels. In 1979, he moved to Alberta. Later, he began
working with a man who had worked with dogs all his life and who,
in the course of discussions with the appellant, recommended a
breed called German Wirehair Pointer, a water dog, weighing 55-60
pounds, with hard, flat dense hair. The appellant stated he
undertook some research on this breed and purchased, for the sum
of $400, a male named Major from a breeder at Medicine Hat,
Alberta. Major, in 1988, became a Show Champion at a particular
competition. There are individuals interested in hunting who are
willing to pay the sum of $600 for a pup and the appellant stated
he now has six female and five male dogs and is able to sell a
year-old female for $1,000 and a two-year old, trained, dog for
as much as $2,500. He is also in the process of constructing a
log home on the property and, in order to do so, purchased a
crane and a tractor. McNally referred to a Statement of Income
and Expenses - Exhibit A-1 - pertaining to his 1993 taxation
year. Filed as Exhibit A-2, was a Statement of Income and
Expenses for his 1994 taxation year and, as Exhibit A-3, a
Schedule indicating gross revenue, expenses and losses for the
years 1989-1994, inclusive, arising from the operation of his dog
business. He also filed, as Exhibits A-4 and A-5, a series of
photographs depicting the property at Calahoo during different
seasons, some dogs, some horses, and pens for the pheasants. The
appellant explained he constructed a road in 1993 in order to
cross a stream and coulee because his dogs require water for
training and he must raise ducks on the pond which are also used
in the development of the dogs' hunting and retrieving
skills. All competitions involving the German Wirehair Pointers
are carried out by dog owners or handlers who are mounted on
horses, running the dogs, and the competition judges are also on
horseback. The dogs compete in a hilly area, over a time period
of 30 minutes, in which they are to locate pheasants, quail and
other game birds which have been planted on the property by the
competition organizers and are then flushed by someone firing a
starter's pistol. In order to obtain maximum points from the
judges, the dogs must work with a minimum of direction from the
mounted person. The appellant stated it was necessary to purchase
horses for the purposes of training his dogs and discovered a
breed of horse called Tennessee Walkers which walk very smoothly
and make it much more comfortable for the rider during the course
of an arduous week-end competition. He now has one thoroughbred,
aged six, one three-year old stud and three mares. He explained
it was cheaper to buy a crane - at $5,000 - in order to assist
with the construction of the log house on the property than it
was to rent one at a high hourly rate. In any event, in 1997, he
sold the crane for the sum of $6,000 and felt it had served him
well in the building process. In 1995 and 1996, the appellant
stated he did not claim any business losses and was trying to
finish construction of the log house - 2,400 square feet - and
could not obtain sufficient loans from any financial institution
to allow him to develop the property more quickly. He stated he
used a portable sawmill in order to reduce the costs of
construction. He had also decided to purchase pheasants for use
in training the dogs but the incubator broke and the eggs
spoiled. The appellant stated that his inventory of animals on
the property at present is as follows: six female dogs, four
of breeding age and two pups, and four males, one of whom, JR, is
a Field Champion, and another is JR's offspring, Cocoa, and
five horses, including three mares and one colt, two pheasants
and 25 hens. The appellant stated that his dogs have done well,
over the years, in various competitions. In 1995, he won second
place in a competition for the top pointing dog. In 1991, Major
finished first out of 32 dogs and another dog finished second in
a trial held in Seattle. The appellant stated he turned down an
offer of $8,000 for Major because the dog was needed to provide
quality pups. There are problems associated with breeding dogs
and, in 1993, nine pups died at birth. However, there is usually
no difference in quality between surviving pups in a litter.
Because his dogs are of excellent quality, the appellant stated
he now needs to locate some wealthy people to purchase the
animals. The German Wirehair Pointers make good pets, are quite
versatile and have a lot of stamina. A six-week old pup can be
sold for as much as $800 but he attempts to screen buyers so as
to have some assurance the animals will be properly exercised. He
stated the ideal inventory is five females and five males
because a larger number than that requires additional time and
the available time for a training period per dog becomes reduced.
In 1993, he did some dog training for others but found it not to
be worthwhile and he abandoned that line of endeavour. The
appellant stated he has all the proper training facilities and
the normal fee is $450 per month per dog for a limited training
session of three months. However, he indicated the dogs have
to be worked all year-round because, "all they know is how
to find birds". He regards his dog operation as having all
the required attributes in order for it to be successful
including 80 acres of land, fields for hay, land for growing
grain for the birds he raises to use during training and room for
the horses.
[3] In cross-examination, the
appellant stated that, for the most part, entry fees, hotels and
travel to competitions would remain the same. The advertising
would increase in some years and the license and insurance costs
would be nearly the same in each year. The dogs are not insured
against loss. He would continue to incur veterinary bills, even
though he provides a lot of this care on his own, but his
interest costs have been reduced and the maintenance and repair
costs were high during 1993 and 1994 because there was a need to
purchase a lot of small tools. He no longer has any need to pay
wages to assist him as his friend and her son live on the
property. He also stated he has a flock of 100 pigeons which he
used for training the dogs. The appellant agreed his expenses
during the years from 1991 to 1994, inclusive, ranged from
$34,022 to $42,535 while his income was $7,500 in 1991, $8,400 in
1992, $7,785 in 1993 and $14,552 in 1994. He conceded that, in
order to generate sufficient income to meet even the current
expectation of reduced expenses, he would have to sell a minimum
of 35 pups per year at a price of $600. He indicated that many
sales occurred as a result of referrals from persons who were
familiar with his dogs. In response to a question about his
commitment to his dogs, the appellant replied, "I will be
involved with hunting dogs until the day I die".
[4] Counsel for the respondent
submitted there was no reasonable expectation of profit during
the years under appeal as the evidence showed the appellant had
accumulated losses in excess of $148,000 since 1989 and did not
have the capacity to generate a profit during the years under
appeal or thereafter.
[5] In Tonn et al. v. The
Queen, 96 DTC 6001, the Federal Court of Appeal examined the
concept of reasonable expectation of profit as it has evolved
over the years since the judgment of the Supreme Court of Canada
in Moldowan v. Q. [1978] 1. S.C.R. 480. Linden, J.A.,
writing for the Court, undertook the analysis and, reproduced
below, is a review of the case law commencing at page 6009 of the
reasons of His Lordship:
"A closer look at this jurisprudence will illustrate that
this is the approach now taken in most of the cases. 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. Though these
activities may in some ways be operated as businesses, the cases
have generally found the main goal to be personal. Any desire for
profit in such contexts is no more than a "pious wish"
or "fanciful dream". It is only a secondary motive for
having set out on the venture. 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.
One such hobby case is McKay v. M.N.R. where
Brulé T.C.C.J., in deciding that an underwater diving
instruction and photography operation did not comprise a
business, stated:
Although the Appellant's course of action
demonstrated a dedication to the scuba diving field, this is not
sufficient to take it beyond the character of a mere hobby. In my
view, on the basis of all the evidence, the Appellant has failed
to establish that he did possess a reasonable expectation of
making a profit from an underwater diving instruction and
photography business for the years under review.
It is not that the impugned activities in these cases are in
themselves any more or less prone to being run like a business.
Rather, it is the simple fact of how they are run which is
decisive: though the taxpayer might well desire to profit from
the activity, the profit motivation is not the main reason for
the activity. Rather, the element of personal enjoyment is the
dominant, motivating force.
In another hobby case, Escudero v. M.N.R., the
applicant deducted losses arising from a dog-breeding operation.
Though the operation was run ostensibly as a business, the
taxpayer had an obvious personal interest in dogs, which was
evidenced, among other things, by the fact that the appellant had
purchased a mobile home for attending dog shows. In deciding that
the deductions were correctly disallowed, Chairperson Cardin
stated:
Although the appellant's breeding kennel may be
operated in a business-like manner, it lacks, in my opinion, the
one essential ingredient to make it a business and that is a
reasonable expectation of profit. On the basis of the evidence
and particularly the financial statements for the years 1975 to
1980 inclusive, I do not believe the appellant can, in the
foreseeable future, reasonably expect to realize the profit from
the operation of his breeding kennel. For whatever reason the
appellant may have engaged in the breeding of pure stock St.
Bernard dogs, it was not, in my opinion, for the purpose of
realizing a profit from the breeding operations.
A further case illustrating the personal benefit
element in Huot v. M.N.R. In this case, the taxpayer
acquired certain properties from his parents and in turn rented
one of them to his parents for a rental value far below the
market rate. The applicant then attempted to deduct losses
arising from this arrangement. The Tax Court Judge properly found
that the applicant did not entertain a reasonable expectation of
profit and dismissed the appeal.
Lastly, in Maloney V. M.N.R., a taxpayer rented a house
she had purchased from her mother back to her for a low rent and
attempted to deduct the losses incurred. In deciding that a
motive of personal benefit predominated in these circumstances,
the Tax Court Judge stated:
I do not doubt in any way the good faith of the
Appellant. She presented her own appeal with sincerity and
conviction. I find, however, that the plan for the mother to be
self-supporting and thereby pay a reasonable rent which would
permit the Appellant to derive income from the property is a plan
that was not well thought out. The subjective, good faith,
commercial hopes and dreams of an individual taxpayer do not
confer upon his or her enterprise a reasonable expectation of
profit if that enterprise does not meet the objective criteria of
a prudent business in similar circumstances.
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. Usually these deductions are not challenged by the
Department, and, therefore, they do not get appealed and are not
reported very often in the law reports. The Courts still have a
role, however, in deciding whether there exist less apparent
factors which might suggest a different conclusion in cases such
as these. The Courts are less likely to disallow these expenses,
but they do so in appropriate circumstances.
Thus, in Baker v. M.N.R., Couture C.J.T.C. found
that the taxpayer conducted himself in a business-like manner and
that it would not be appropriate to disallow the deductions he
claimed:
In the present appeal, it appears to me that the
Appellant conducted himself like a normal average investor, an
investor who was not sophisticated because of lack of
professional training, but who nonetheless had a working
knowledge of the basic rules of the investment process. He knew
the area where the property was located. He had received
assurances from the real estate agent that there would not be any
problem renting the property throughout the year and furthermore
the agent had indicated the rent that could be obtained. ...The
fact that the rental projections did not materialize, which was
the main and only cause of the failure of the venture certainly
cannot be imputed to the Appellant. It was simply part of the
risk related to the venture.
In a contrasting case, the taxpayer attempted to deduct rental
losses on a property. While recognizing that it is inappropriate
for the Minister or the Court to substitute its business judgment
for that of taxpayer, Bowman, T.C.C.J. found that the operation
did not meet the Moldowan criteria:
Nonetheless, there must be sufficient of the indicia of
commerciality to justify the conclusion that there is a real
commercial enterprise being conducted. I do not find that the
arrangements made by the appellant contain those indicia. The
100% financing, the payment of a 25% commission to Port Charlotte
Homebuilders and the substantial expenses and consequent loss in
comparison to the gross revenues and the overall cost of the
property are among the factors that I find inconsistent with a
genuine commercial operation.
This conclusion does not of course justify the
automatic disallowance of losses in the early years of a genuine
viable rental operation. There should be a reasonable period in
which to permit the enterprise to become self-supporting. In the
years under appeal, I do not think it had reached the stage where
it can be called either a business or a viable rental
operation.
Other cases utilize the Moldowan case in what
appears to be regular commercial type situations exist. The
facts, of course, are always of importance in sorting out which
cases will be placed on the other side of the line. Hence, where
a commercial enterprise is operated at a loss in order to
generate tax refunds or other such tax consequences, the Court
will likely find that the enterprise is not a business under the
Moldowan test. In other situations, 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. This was the situation before
this Court in Landry v. Q. In deciding that a
lawyer's expectation to earn a profit from a rejuvenated
legal practice, recommenced in his seventies, was not objectively
reasonable, Décary, J. stated:
It is possible for someone, with the best will in the
world, to practise an activity that takes all his or her time and
that activity may still not be a business for the purposes of the
Income Tax Act. ...There comes a time in the life of any
business operating at a deficit when the Minister must be able to
determine objectively, after giving someone a head start for a
number of years, as the case may be, that a reasonable
expectation of profit has turned into an impossible dream.
I might note for the record that the factual
circumstances in Landry were not entirely free from suspicion.
One significant source for the losses claimed in the case was
part of the cost of the personal residence of the taxpayer from
which the practice was run at least part of the time.
In another case, Engler v. Q. a taxpayer
attempted to deduct losses from a small business he formed to buy
and sell various gift items such as brassware, watches, rings and
household gadgets. The profits intended from this business were
to supplement the taxpayer's employment income. Though
no personal element was apparent in how the taxpayer ran the
business, and though the type of business suggested a bona
fide commercial operation, the losses arising from it were
held to be non-deductible because the venture lacked a reasonable
expectation of profit. Even though the operation could not
otherwise be impugned, the rather large losses claimed were too
suspicious to be overlooked, thus suggesting that a
non-commercial intention lay at their source. In deciding the
matter, Joyal, J. stated:
On the evidence, it might be said that the plaintiff
originally brought the whole controversy upon himself by claiming
expenses which could not by any stretch of the imagination be
justified. In the face of this obvious disproportion between the
resulting losses and the volume of business generated, or the
capital committed, or the time and energy devoted to it, it was
an easy slide from a determination of the unreasonableness of the
expenses to an assumption that the venture, in any event, did not
have a reasonable expectation of profit.
I also find the following words from earlier in the judgment
instructive:
It is only when the taxpayer has other sources of
income against which any such losses are claimed that Revenue
Canada's antennae start sending out signals which might
become a source of concern to the taxpayer. Depending on the
circumstances in each case, Revenue Canada will assume that the
taxpayer is engaged in a business which objectively has no
reasonable expectation of profit. The inference will be drawn
that the taxpayer is merely engaged in a sport, hobby or some
other self-satisfying endeavour, and if his losses are
charged to his other sources of income, he is effectively
reducing his tax exposure.
The difficulty the taxpayer could not overcome was the
inference, derived from the unreasonable nature of the expenses,
that the business was in fact not operated for business
reasons.
When the cases are categorized into two groups as
above, one cannot help observing that the hobby and personal
benefit cases are rarely decided in the taxpayer's favour. In
contrast, 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. I also note that in terms of sheer numbers,
the hobby/personal-benefit cases vastly outnumber those of the
commercial activity and variety, which are quite rare, indicating
that taxpayers are challenged less often in such situations.
The primary use of Moldowan 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. This
point was stated strongly by Sheldon Silver:
It is submitted that it should not be the role of
Revenue Canada to determine what businesses taxpayers should
attempt to pursue. In fact, governments in Canada have often
stated that new businesses and risk-taking should be encouraged
and have, from time to time, enacted legislation to encourage
such activity. Canadian chartered banks have recently been
seriously criticised by the press and government officials for
not providing adequate lending facilities to small and new
businesses. Clearly, Revenue Canada's attempt to penalize
taxpayers who are unsuccessful after taking these risks is
inconsistent with the government's promotion of private
entrepreneurs.
This criticism was echoed by Bowman, T.C.C.J. in
Bélec v. Q. where he stated:
It must be noted that these losses were incurred solely
in a business context. There was no personal element, either in
his purchase nor in his use of the building. The appellant is an
experienced businessman. He took his decision in good faith on
his best judgment and on the facts available to him at the time.
It is not up to the Minister (or this Court) to substitute his
business acumen for that of the taxpayer, with the benefit of
hindsight. The question to be asked is not, "Knowing what I
know now, would I have embarked upon this enterprise?" The
answer is no doubt "No", because the question only
comes up when there are losses.
And finally, the same caution was reiterated in Nichol v.
Q.:
[Mr. Nichol] made what might, in retrospect, be seen as an
error in judgment but it was a matter of business judgment and it
was not one so patently unreasonable as to entitle this Court or
the Minister of National Revenue to substitute its or his
judgment for it, or penalize him for having made a judgment call
that, with the benefit of 20-20 hindsight, that Monday morning
quarterbacks always have, I or the Minister of National Revenue
might not make today. We were, after all, not there in 1986.
Though I do not support the use in the Nichol case of
the word "patently", I otherwise agree that 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. However,
where circumstances suggest that a personal or
other-than-business motivation existed, or where the
expectation of profit was so unreasonable as to raise a
suspicion, the taxpayer will be called upon to justify
objectively that the operation was in fact a business. Suspicious
circumstances, therefore, will more often lead to closer scrutiny
than those that are in no way suspect."
[6] It is apparent from the evidence
the appellant has long held an interest in hunting dogs and
indicated this devotion would continue as long as he lived. The
difficulty in these types of cases is that, in order to be
successful, one has to be extremely dedicated to the particular
type of animal and to be willing to do what is required including
adopting the appropriate lifestyle. The nature of the examination
required is an objective one, involving the head - as opposed to
- the heart. The appellant was attempting to do too many things
at once. He embarked on a course of action which appeared to
involve his own concept of vertical integration so that he could
become nearly self-sufficient in order to control quality and
reduce costs. He purchased 80 acres of land so that he would have
the space required to train the dogs, including the land-base
needed to raise the horses - Tennessee Walkers - and to provide
adequate water in the forms of streams and ponds in order to
raise ducks. He also raised pheasant and pigeon to use in the
training of the dogs. Then, he was building a house which he
indicated was necessary in order to accommodate visitors to his
business and he purchased a crane and a tractor to assist in the
construction. There was a great deal of expense in constructing
the runs and the kennels. He entered his dogs in competitions and
had a high degree of success which he believed would lead him to
the point where his pups would be in demand by people who would
pay excellent prices in order to own such a quality dog. The
development of this elaborate superstructure was undertaken to
create an inventory of 10 dogs, only four of which were breeding
females, in 1997. These four dogs and the male studs the
appellant owned had to produce enough saleable offspring to
support the costs of running the 80 acres, the buildings, paying
interest charges, veterinary bills, fuel, automobile expenses,
capital cost allowance, feed and care for five horses, and an
assortment of game birds. The competitions themselves produced no
money by way of prizes so the appellant's opportunity to
realize a profit was from selling sufficient pups in order to
generate adequate income even though, in 1994, the appellant had
income of $7,400 from the sale of two horses and another $1,500
from selling pheasants. The appellant continued to work full time
at the CN. During the years in issue, he would have had to sell
nearly 70 dogs per year in order to break even. This is difficult
to do even though the appellant had stated he believed it should
not be that difficult to get 14 pups - in two litters per year -
from each female, and, if he had six breeding at once, could end
up with 84 pups. However, the most pups he ever sold was 13, in
1994, and, as a result of the assessment by the Minister
disallowing his losses, he stopped selling dogs in 1995 and 1996
and turned his attention to finishing the house. Apart from the
personal element involved in the within appeal, the ability of
the enterprise to function under circumstances where it might
have a reasonable expectation of profit was hampered by the lack
of maturity of the activity, as structured, to be anything other
than a pursuit - in the early developmental stages - of a
country-gentleman dog-fancier looking to create an idyllic
hunting dog resort in the country near a metropolitan area. There
is no doubt the appellant has a lovely place which might be well
suited to a bed and breakfast or a cross-country ski hide-a-way
but it did not have the capacity to pump out enough revenue in
the years under appeal, and thereafter, to pass the business
test. Although the appellant stated he was searching for a profit
- as opposed to merely satisfying a personal hobby - and had gone
through the earlier years from 1989 to 1992 during which he
relocated and expended time, money and energy to improving the
property and making it suitable for his needs - his projections
were not reasonable. Moreover, his decision to stop the activity
in 1995, and thereafter, because losses had been denied him by
the Minister's reassessment does not leave one in the
position of having evidence of what might have been had he stayed
the course. It was not necessary to get into the nitty-gritty of
the appellant's view of what is a properly deductible
business expense but the appellant had claimed certain expenses
which - at best - would be on account of capital, such as road
construction, and I fail to see how any costs associated with
building a private 2,400 square-foot residence can be apportioned
against the purported business - the raising and sale of
dogs.
[7] The Minister's assessment is
correct and the appeal is hereby dismissed.
Signed at Sidney, British Columbia, this 6th day of February
1998.
D.J.T.C.C.
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