Citation: 2007TCC321
Date: 20070716
Docket: 2005-528(IT)G
BETWEEN:
RENE NUYTTEN,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Archambault J.
[1] Mr. Rene Nuytten
is appealing an income tax reassessment respecting the 2000 taxation year. In his
reassessment, the Minister of National Revenue (Minister) disallowed a business
expense of $34,700 that had been claimed in the original tax return. He also
disallowed an additional amount of $218,042 claimed by Mr. Nuytten as
research and development (R&D) expenses in a T1 adjustment request
to amend his tax return. At the outset of the hearing, counsel for
Mr. Nuytten indicated that he was not contesting the disallowance of the
$34,700. However, he argued that Mr. Nuytten was entitled to the deduction
of $218,042 on the basis that this amount constituted R&D expenses that
were deductible pursuant to section 9 of the Income Tax Act (Act)
in computing Mr. Nuytten’s business income.
[2] When he issued his
assessment, the Minister assumed as facts that Mr. Nuytten had carried on
an R&D activity with respect to advanced deep-sea diving systems (activity)
(subparagraph 12a) of the Reply to the Notice of Appeal), that
Mr. Nuytten had begun this activity in 1996 (subparagraph12b) of the
Reply) and that in 2000 this activity constituted a business carried on by
Mr. Nuytten (subparagraph 12c) of the Reply). However, before this
Court, he advanced a different position and argued that the activity did not
constitute a business or a source of income for the appellant in the 2000
taxation year (paragraph 13 of the Reply). Therefore, it is the Minister
who bears the onus of establishing that the activity did not constitute a
business carried on by Mr. Nuytten.
[3] Both parties
presented written submissions during oral argument. There is not much dispute
as to the relevant facts. However, there are some slight differences in the
parties’ description of the facts. I shall first reproduce the statement of
facts presented by counsel for Mr. Nuytten:
4. The Appellant, Mr. Nuytten is a world-class Canadian
inventor who for almost 5 decades has been involved in advancing deep sea
diving technologies and a variety of spin off technologies.
5. Mr. Nuytten’s biography is impressive and worthy of careful
review. Highlights include that he is a world leader in the diving community,
has appeared on the cover of numerous magazines such as National Geographic and
was the recipient of several Canadian government awards of excellence and
awards from industry groups (both Canadian and foreign). He is a recipient of
the Order of British Columbia, had an honorary doctorate conferred on him from
Simon Fraser University and is regularly engaged by groups such as NASA and
television and film producers because of his expertise. He is a true Canadian icon
in his field.
6. After becoming interested in diving, he started his own
dive shop while still in high school. After high school, Mr. Nuytten dedicated
his working life to the technology of underwater diving and related activities
beginning with a commercial diving company called Can-Dive Services Ltd.
(“Can-Dive”).
7. After the successful start up of Can-Dive, he joined two
like-minded individuals in founding Oceaneering International. As part of
founding Oceaneering International, Mr. Nuytten transferred Can-Dive to
Oceaneering International.
8. At Oceaneering International, Mr. Nuytten was the Sr. Vice
President of Technological Development and guided all research activities and
personally performed field work and trials. Projects at Oceaneering International
included an ROV (or, remote-operating vehicle) submarine, “bouns” diving bell
systems and saturation diving systems. While Mr. Nuytten was at Oceaneering
International, it prospered and gained an international reputation.
9. Mr. Nuytten left Oceaneering International in the mid-1980s
to pursue his own projects. When he left, he repatriated Can-Dive from
Oceaneering International.
10. Through the newly repatriated Can-Dive, Mr. Nuytten worked
on developing what would become known as the “Newtsuit”, a revolutionary “one‑atmosphere”
diving suit designed to allow deep ocean dives to depths never before possible
and surfacing without the need for time-consuming and hazardous decompression.
The Newtsuit also allowed a measure of dexterity at deep levels that could be
offered by no other product.
11. Can-Dive and the work on the Newtsuit were eventually
transferred to a new enterprise, International Hardsuits. The transfer took
place because development of the Newtsuit and his other projects required more
financing than his personal resources allowed.
12. At International Hardsuits, Mr. Nuytten continued work on
the Newtsuit to the point where he had a marketable product.
13. While at International Hardsuits, he also developed
“Remora”, a new and unique submarine rescue system.
14. International Hardsuits obtained public financing and was
listed on the Toronto and Vancouver stock exchanges. Through these public
offerings, Mr. Nuytten’s interest in International Hardsuits was reduced from
his original 100% shareholdings to below a controlling interest.
15. Both the Newtsuit and Remora drew interest from navies
around the world. This attention brought with it the possibility of lucrative
contracts for International Hardsuits.
16. An American corporation named American Oilfield Divers saw
the potential in International Hardsuits and launched a hostile takeover.
17. Mr. Nuytten vigorously opposed the takeover but, because of
his minority position, was not able to block it. In the result, Mr. Nuytten was
ousted from International Hardsuits and the technology that he developed stayed
with International Hardsuits.
18. In light of his unpleasant experience with the hostile
takeover of International Hardsuits, the Appellant sought a method by which he
could ensure that any new technologies would belong to him personally.
19. After being ousted from International Hardsuits, the
Appellant created Nuytco Research Limited (“Nuytco”) in late 1996. He was, and
remains, the sole shareholder of Nuytco.
20. The Appellant envisioned two main projects for Nuytco.
First, a small deep-diving submersible now called a “Deep Worker”. His thought
was that once the Deep Worker project had succeeded to the point that it was
producing revenue, he would move on to his second project, an improved version
of the Newtsuit called the “Exosuit”.
21. The Appellant made the deliberate decision when he started
Nuytco that he wanted to personally retain the technologies so that if Nuytco
fell into unfriendly hands through hostile takeover, bankruptcy or any other
reason, he would at least control the technology.
22. His concept was to divide the business between Nuytco and
the Appellant in his personally [sic] capacity. He would develop the
technology using his own funds thus ensuring that he owned the technology. This
would give him the freedom to use the technology as he saw fit. This might
include sales or licensing to third parties, or making the technology available
to Nuytco.
23. In concept, the logistics were that amounts to be charged to
Mr. Nuytten were paid by Nuytco because it had the relationship with the
suppliers. Theses amounts were accumulated and charged against Mr. Nuytten’s
shareholder loan account.
24. The evidence on the execution of this plan prior to 2000 is
not entirely unclear. It is clear that expenses were charged to Mr. Nuytten at
least in 2000 and that throughout the entire period, he viewed that technology
as belonging to him.
25. The Minister assumed in assessing the Appellant that Mr.
Nuytten had been doing the R&D Activity in his personal capacity since 1996
(Reply, paragraph 12(a)) and that Mr. Nuytten had reported losses from the
R&D Activity each year up to and including 2000 (Reply, paragraph 12(q)).
As a result, the billing and deductions of amounts in prior years were not put
into dispute in this appeal. Had these prior years been put into dispute, a
clearer evidentiary picture could have been made available to the Court.
26. The Expenses claimed in the 2000 taxation year involved
seven projects. The costs for these projects were gathered in Nuytco but billed
personally to the Appellant thus ensuring that it was clear that he personally
funded the technology and was its owner.
27. The Expenses were claimed by the Appellant by filing a T1
ADJ which included not only the
claim for the Expenses, but also salary from Nuytco of $499,309 which was the
amount necessary for Nuytco to “bonus down” to the “business limit”.
28. Several of the projects to which the Expenses relate were
accessories or sub-systems ancillary to the Deep Worker, which was the main
revenue producer for Nuytco. Other projects involved the Exosuit and still
others had multiple potential applications.
29. When the work at issue in this appeal was being performed,
the four projects that make up the bulk of the Expenses were at various stages
which can be summarized as follows:
a. The manipulator arm design project was intended to provide
a revolutionary breakthrough which would allow for superior dexterity compared
to conventional undersea remote arm systems. In the end, that breakthrough was
not forthcoming, and the few “Newtarms” that were sold were replaced with
conventional technology. Hindsight proves the technological uncertainty of that
project because it failed.
b. The electronic research and development project covered
several ideas. Mr. Nuytten explained the difficulty of developing electronics
at a time when the world was rapidly switching from analogue to digital with
the result that test results and product platforms quickly became obsolete.
These projects were of benefit to the development of the Exosuit, the Deep
Worker and a variety of other projects.
c. Newtsub development entailed classic trial and error
testing to make product improvements and accessories to increase the
functionality of the Newtsub. The very nature of this type of trial and error
testing means that the technological issues had not been resolved.
d. Design Drawing was essentially support for other projects,
and part of the development process.
30. Nothing in the seven projects in 2000 found their way into
the patent for the submersible obtained by Mr. Nuytten in 2002 because is was
an ornamental design patent.
31. The Appellant testified that he did not have much of a
belief in the patent
process and in his long career had patented only a few inventions. He made it
clear that when he was performing the R&D Activities that are the subject
of this appeal, he was not pursuing patents.
32. In 2000 year, the Appellant began to conclude that Nuytco
was likely to be self-sustaining financially and could carry on without the
need for outside financing. Thus, he found it no longer necessary to divide the
business between Nuytco and himself. Accordingly, Nuytco took over the R&D
aspects of the business from the Appellant and the Appellant ceased personally
funding the R&D.
33. However, he had a slight change of plan with respect to the
Exosuit. On May 1, 2001, Mr. Nuytten and Nuytco entered into a Royalty
Agreement concerning only the development of the Exosuit. Mr. Nuytten viewed
the Royalty Agreement as a way to ensure he continued to own the Exosuit
technology without having to personally fund the R&D. Under the Royalty
Agreement, Mr. Nuytten would perform the work and own the intellectual property
resulting from that work. In return, Nuytco would fund the R&D and would
have the opportunity to exploit the intellectual property in exchange for a
payment based on the greater of $50,000 per year or 1½% royalty starting in
2003.
34. An evidentiary point is whether the Royalty Agreement covers
Exosuit technology owned by Mr. Nuytten prior to May 1, 2001. The Royalty
Agreement speaks for itself, and it is a matter of contract law if the prior
technology was included. However, the evidence of Mr. Nuytten was clear that he
viewed this as including his past technology.
[4] The most relevant
part of the description of facts presented by counsel for the respondent is
found in paragraphs 10 to 32 of his written submissions, which provide facts
in addition to those set out by counsel for Mr. Nuytten:
Nuytco
Research Ltd.
10. In late 1996, the Appellant commenced research and
development through Nuytco Research Ltd. (“Nuytco”). The Appellant is the sole
shareholder and director, and an employee, of Nuytco.
11. Nuytco’s primary business objectives were to develop and
market a new submersible, which became the “Deep Worker”, and then an improved
undersea suit, which became the “Exosuit”.
12. Nuytco began research and development operations in earnest
in 1997. Until 1999, Nuytco financed its own research.
13. Nuytco sold its first Deep Worker submersible in 1998. In
that same year, Nuytco secured a five-year contract with the National
Geographic Society to charter submersibles for a project involving undersea
mapping and filming of 13 United States Marine Sanctuaries. Nuytco also secured
contracts with NASA, local utility companies, and other clients.
14. In 1999, the Appellant concluded that the Deep Worker
submersible would be a successful product, and he became concerned about losing
control of the intellectual property relating to the Deep Worker if for some
reason he lost control of Nuytco.
15. On the advice of his accountant, the Appellant implemented a
mechanism through which the costs of Nuytco’s research from January 1 to April
30, 2000 were charged to him at Nuytco’s year-end so that the Appellant would
own the resulting intellectual property. Nuytco produced an invoice on August
30, 2000, charging the Appellant a total of $218,042 for research costs from
January to April 2000.
16. With a 5-year contract from the National Geographic Society
in hand, the Appellant concluded that Nuytco would be financially successful
and would not need outside investors to finance the Deep Worker. Therefore,
after April 30, 2000, the Appellant ceased assuming the research costs
personally.
17. The year 2000 was the only year that the Appellant assumed
liability for Nuytco’s research costs. Nuytco has paid all research costs
since.
18. In its 1999, 2000 and 2001 taxation years, Nuytco reported
the following gross sales and net income before tax:
|
Taxation Year End
|
Gross Sales
|
Net Income
Before Tax
|
|
|
|
|
|
April 30, 1999
|
$1,077,000
|
$166,730
|
|
April 30, 2000
|
$2,700,683
|
$193,741
|
|
April 30, 2001
|
$1,728,811
|
$155,111
|
The Appellant’s Intentions for his Research in 2000
19. The Appellant personally funded the research in the [sic]
2000 in order to preserve personal ownership of any resulting intellectual
property. The research related to the Deep Worker submersible concept that
Nuytco had developed and was improving, as well as to other small products such
as a manipulator arm, HMI lights, and an underwater telephone. Some of the
research product would also be applicable to the upcoming Exosuit project.
20. The Appellant generally prefers not to patent his
developments unless they are completely new because registering a patent
announces the discovery to the outside world and invites competitors. The
Appellant has registered only five patents: two for the Newtsuit, one for the
Remora, one for the external design of the Deep Worker, and one for the
“Morpheus” system. Ownership of the patents for the Newtsuit and Remora were
lost when Hard-Suits was acquired by American Oilfield Divers.
21. Although the Appellant did not intend to create patents that
he could license for royalties, he did intend to create valuable intellectual
property assets such as know-how, processes, designs, drawings, prototypes,
models, and so on.
22. The Appellant did not intend to exploit those assets himself
by producing and marketing the submersible or other products outside of Nuytco.
All of his research products were incorporated into Nuytco’s business.
23. In 2000, the Appellant’s research activity generated no
revenue of any kind. Nor did he have any arrangements in place to receive
royalties or other compensation from Nuytco for its use of those assets in the
Deep Worker submersible.
Royalty Agreement and Patent
24. In 2000, the Appellant began work
developing the Exosuit. He realized that the Exosuit would be a more expensive
project than he originally expected, and he again became concerned about losing
control of the Exosuit technology if it became necessary to transfer the
project into another company and to raise outside capital.
25. On May 1, 2001, the Appellant and Nuytco signed a Royalty
Agreement under which Nuytco retained the Appellant to perform research and
development relating to the Exosuit. The Agreement provided that all
intellectual property developed by the Appellant would remain his property.
26. However, the Royalty Agreement gave Nuytco a “perpetual,
worldwide right and license” to use any intellectual property developed by the
Appellant, and required Nuytco to pay the Appellant the following royalties for
that license:
a. From 2003 until 2010, the greater of 1.5% of Nuytco’s gross
revenues from sales or licenses of products using his intellectual property or
$50,000 per year; and
b. After 2010, 1.5% of Nuytco’s gross revenues from sales or
licenses of products made with his technology for as long as Nuytco made sales.
27. The Appellant explained that the 2001 Royalty Agreement
guaranteed him an income stream from his research activity. If Nuytco was
unable to pay the royalty, control of the intellectual assets would revert to
him and he could do whatever he wished with them.
28. The Exosuit is not yet in production and it is not
generating sales for Nuytco. Since 2004, the Appellant has received $50,000 per
year from Nuytco under the Royalty Agreement.
29. The Appellant obtained a patent in the United States for the
exterior design of the Deep Worker submersible on August 13, 2002. The patent
was assigned to Nuytco. The Deep Worker design patent was not contemplated by
the Royalty Agreement. There is no evidence that the Deep Worker design patent
has generated income to the Appellant.
The Appellant’s Income and Expenses in 2000
30. The Appellant’s 2000 tax return
reported income from taxable dividends, interest and other investments, and
taxable capital gains. The Appellant does not recall the dividends reported
were from Nuytco.
31. The Appellant’s 2000 tax return also reported $1 of gross
business income and a net business loss of $34,700. The $34,700 reflects
amounts that are no longer in issue in this appeal.
32. By a Request for Adjustment filed by the Appellant’s
accountant in December of 2001, the Appellant requested additional business
expenses of $218,042 resulting from the research costs charged to him by
Nuytco.
[5] The appellant’s
position is outlined in paragraph 2 of his trial brief:
2. The Appellant’s
position is that these R&D Activities constituted a business of the
Appellant and that the Expenses are deductible in computing income from that
business in accordance with s. 9(1) of the Income Tax Act (the “Act”).
Further, the deduction of the Expenses is not prohibited by s. 18(1)(b) as
being on account of capital.
[6] Counsel for the
respondent’s position is outlined in his overview at page 1 of his written
submissions:
OVERVIEW
The Appellant’s research activity was not
a business or other source of income for tax purposes in the 2000 taxation
year. The evidence does not support the conclusion that the Appellant undertook
the research in pursuit of personal profit. The predominant purpose for the
Appellant funding the research personally was not to generate profit
personally from operating a business separate from Nuytco’s, but to
maintain personal control of intellectual property assets intended to be
used by Nuytco to produce its Deep Worker submersible. The Appellant has earned
no income personally from the research done in the year 2000, either in 2000 or
subsequently.
The evidence indicates that the research
paid for by the Appellant in 2000 was effectively integrated with Nuytco’s
business. Everything that Nuytco produces is based on his research. In
addition, Nuytco originally paid for that research from 1997 until 1999, and
did so again from 2001 onward. Finally, when the Appellant was satisfied that
Nuytco would be financially successful he discontinued the arrangement and
Nuytco resumed paying for the research.
Even if the Appellant’s research was a
business in 2000, the expenditures were capital expenditures that may
not be deducted in full. Their purpose was to create assets that would give
enduring benefits to the Appellant by generating future income and by being
used in future products. Since patents are “depreciable property” for purposes
of the Income Tax Act, expenses that led to the US Design Patent for the
Deep Worker assembly were the capital cost of a Class 44 asset. Expenses
that did not result in the creation of any patent are, at most, eligible
capital expenditures. However, deductions for eligible capital are
available only for businesses, not taxpayers earning income from property.
The evidence discloses no patents or
other depreciable properties held by the Appellant in the 2000 year. Therefore,
he may not claim any capital cost allowance in that year, and the “leasing
property” restrictions in the Regulations are not applicable.
[My emphasis.]
Analysis
[7] I would like to make
some general comments on the more relevant facts and highlight some of the
disturbing ones with regard to what took place during the relevant period in
this appeal. I begin by observing that Mr. Nuytten was a fascinating
witness to listen to. He appears to be a genius in coming up with designs for submersibles
like the “DeepWorker” or atmospheric diving suits, such as the “Exosuit”. He
also described a new submersible, which he called “Morpheus”, for exploring the
tunnels used by large cities like New York to transport fresh water to their
citizens. However, as far as the administration of his company’s business is
concerned, he relies on hired professionals. Unfortunately, he was not in a
position to describe accurately at the hearing what took place in relation to
the R&D expenses. For instance, he could not state with enough precision when
he himself started to incur expenses with respect to the development of the
DeepWorker and the Exosuit. He said he relied on his accountant.
[8] However, when he testified,
the accountant stated that the only year for which Mr. Nuytten was charged
for R&D expenses by Nuytco was 2000, or, more accurately, he was charged
for expenses incurred from January to April 2000. This statement by the accountant was
quite a surprise for the Court and, I assume, for Mr. Nuytten’s counsel, given
that the Minister had assumed that Mr. Nuytten had been carrying on the R&D
activity himself from 1996 to at least 2000. But it was Mr. Nuytten’s own
witness, namely, his personal accountant and Nuytco’s accountant, who contradicted
these facts assumed by the Minister.
[9] In addition, when
Mr. Nuytten filed his 2000 tax return on April 29, 2001, he did not
claim any of the $218,042 in R&D expenses; he only claimed a business loss
of $34,700, which resulted from the deduction of “management and administration
fees”. At
subparagraph 12g) of the Reply, it is stated that the Minister assumed
that these fees were paid to Mr. Nuytten’s spouse and daughter for their
assistance with his research and development activities and in starting a
historical diving society. Although he admitted this fact, Mr. Nuytten’s
counsel informed the Court that he was no longer contesting the disallowance of
these expenses. Therefore, it appears that the only expenses that had been
claimed originally by Mr. Nuytten were not incurred for the purpose of
earning income from a business.
[10] The R&D expenses
of $218,042 were only claimed subsequently by filing an adjustment request on
December 18, 2001, approximately 8 months after having filed the
original tax return. In the same adjustment request, Mr. Nuytten added
$499,309 of employment income allegedly paid as a bonus to him. Therefore, it
is plausible that, on the basis of such business deductions as the $34,700
claimed in the past by Mr. Nuytten, which amount Mr. Nuytten now
acknowledges was not properly deductible, the Minister took for granted that
Mr. Nuytten had been carrying on an R&D activity since 1996.
[11] Not only did the
accountant confirm that the R&D expenses were only billed to
Mr. Nuytten in 2000, but the billing took place after a year‑end
journal entry, the sort of entry that is generally made shortly after year-end
(see Exhibits A‑8 and A‑9). The invoice itself is dated
August 30, 2000, but refers to “bill[ed] as of April 30, 2000”.
(Exhibit A-3) The tax return for Nuytco was filed on November 3, 2000, and
it appears to have been filed late and to have been subject to a penalty (see
Exhibit A‑6).
[12] I do not doubt that
Mr. Nuytten, as a result of his past experience in losing control of International
Hardsuits after the hostile takeover by American Oilfield Divers, had serious
concerns about keeping more effective control over his inventions. I do not
doubt either that he meant to take steps to protect his position in case he
allowed other investors to become shareholders in Nuytco. He testified that he
consulted lawyers and accountants about ways to achieve these objectives. However,
I cannot say that I am impressed by the steps that he took to achieve them. He
did not get any formal opinion as to the proper thing to do. In addition, it
appears that most of the expenses for the development of the DeepWorker and the
Exosuit were incurred by Nuytco, not Mr. Nuytten, who failed, therefore, to
establish clearly that he owned the technology developed in the name of Nuytco. In addition, Mr. Nuytten
acknowledged that the money that could be generated from the use of his
technology would be earned through Nuytco, although he also stated that he
could have disposed of his technology himself to another company.
[13] Furthermore, it can
be seen that Mr. Nuytten abandoned his 2000 strategy of incurring the
R&D expenses himself and on May 1, 2001, entered into a Royalty
Agreement with Nuytco whereby he would perform R&D activities for Nuytco as
an independent contractor. It appears that the costs of carrying on the R&D
activities were to be borne by Nuytco. For his services to Nuytco,
Mr Nuytten is entitled to receive during the term of the agreement, which “shall
commence on May 1, 2003 and shall terminate on April 30, 2010”,
the greater of $50,000 per annum and 1½% of all gross revenues derived from the
sale or license of products developed by Nuytco using Mr. Nuytten’s work
or intellectual property. After the expiration or termination of the agreement,
Mr. Nuytten will be entitled to 1½% of all gross revenues derived from the
sale or licence of these products for as long as Nuytco derives revenue from
the sale or licence thereof.
[14] Given these facts,
it is difficult to conclude that Mr. Nuytten was carrying on a business
during 2000. First, there is no agreement in writing that provides for Nuytco
to incur R&D expenses on behalf of Mr. Nuytten or for his benefit. The
evidence produced at the hearing seems to indicate that the charging of the
expenses to Mr. Nuytten was an afterthought that took place in the period
during which the accountant was preparing the financial statements for the
company. The invoice itself is dated August 30, 2000.
[15] Overall, the conduct
of Mr. Nuytten appears to be an awkward attempt to retain control over his
inventions in the eventuality of the acquisition of control of Nuytco by
another investor, and in the meantime Nuytco was intended to be the entity to
make money from the exploitation of the technology developed by
Mr. Nuytten and “his design team”.
This conduct is not consistent with someone carrying on a business for profit.
The business carried on for profit is that of Nuytco and therefore the expenses
in question belong to Nuytco.
In this particular case, it appears that Nuytco will not be prejudiced, since
in forgoing the $218,042 of R&D expenses billed to Mr. Nuytten, Nuytco
paid Mr. Nuytten a large bonus of $499,309 and used the deduction of that
amount to reduce its income below the $200,000 business limit for the purposes
of section 125 of the Act.
[16] Given that the respondent
has succeeded, in my view, in establishing that Mr. Nuytten did not carry on a
business during the year 2000, the amount of $218,042 billed to him by Nuytco
cannot be deducted in computing his income for the 2000 taxation year. This is sufficient
to justify the Minister’s assessment disallowing the deduction of the $218,042.
[17] For all these reasons,
Mr. Nuytten’s appeal is dismissed with costs.
Signed at Ottawa, Canada, this 16th day of July 2007.
“Pierre Archambault”
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