Feldgajer v. R., [1996] 1 CTC 2263

Bowman J.T.C.C.:-These appeals are from reassessments for the appellant’s 1988, 1989 and 1990 taxation years. They involve the disallowance by the Minister of National Revenue of business losses sustained by the appellant relating to a consulting business carried on by him under the name of Feldgajer & Feldgajer Consultants.

Mr. Feldgajer is an undoubted expert in computer technology. His career, which is set out in detail in Exhibit A-2, commenced in 1971, as an electronic technician with the Israel Air Forces and subsequently, until 1982, when he came to Canada, with two Israeli companies, Telkoor or Tadiran, as an electronic technician and hardware engineer. In Canada he worked from 1982 to 1984 for CAE Electronics as a software engineer and from 1984 to 1990 with NCR Canada as a senior software analyst (project leader). He holds a BSc from Tel-Aviv University and a Master of Arts and Science, Electronic Engineering, from Waterloo University. The major areas of specialization at Waterloo University were:

Advance Computer Architectures and Parallel Processing, Computer Networks Communication and Security, Analysis of Computer Communication Networks, Robotic Engineering, Digital Image Processing, Digital Waveforms Coding and Information Processing, Advanced Digital Signals Processing and Artificial Intelligence.

His principal responsibilities at NCR Canada appear to have been in the field of Advanced Neural Networks.

I need not set out in detail his impressive qualifications and experience in the computer field. They would be of interest to (and probably understandable by) only another computer specialist. They are set out in Exhibit A-2. It is sufficient to observe that he has overwhelmingly demonstrated that he was well qualified to embark upon the business venture that he did in 1986.

In 1986 he set up Feldgajer & Feldgajer Consultants. His wife evidently participated with him in it, and as a result both their names appear in the firm name. NCR Canada permitted employees to carry on private consulting businesses provided that they were not in competition with the business carried on by NCR Canada. There was no suggestion in the evidence of any such competition.

From 1986 to 1991 the appellant reported the following income, expenses and loss from the business of Feldgajer & Feldgajer Consultants:

It should be noted that the only large item of income in the years under appeal was about $6,000 which was earned from a contract with ADI Electronics Corporation.

In 1990 Mr. Feldgajer incorporated International Neural Machines Inc. (“INM”) of which he was the majority shareholder. He sold the assets of Feldgajer & Feldgajer Consultants to that company for $6,206.74 and realized a capital gain which was initially shown as income from the business but was, in filing his return, declared as a capital gain.

The losses claimed for the taxation years 1988, 1989 and 1990 were disallowed by the Minister, on the basis, according to the so-called assumptions pleaded in the reply, that:

-the appellant did not have a reasonable expectation of profit in the years 1988, 1989 and 1990;

-the expenses claimed by the appellant in the 1988, 1989 and 1990 taxation years were incurred prior to the commencement of a business; and

-the expenses claimed in relation to the consulting activities were personal or living expenses of the appellant.

I should begin by noting that there is no suggestion that the expenses were not incurred or that they were unreasonable. It was not contended that the expenses were of a capital nature within the meaning of paragraph 18(1)(b) of the Income Tax Act. The only argument of substance was that the expenses were incurred before the business commenced. I shall, however first deal with the other two points.

I can see no merit whatever in the contention that the expenses were personal or living expenses. That expression is defined in section 248 and bears no resemblance to the expenses incurred by Mr. Feldgajer in connection with what the respondent somewhat grudgingly describes as the “consulting activity” (no doubt to avoid any suggestion of an admission that what he was doing was carrying on a business).

The argument that the appellant had no reasonable expectation of profit is based upon the frequently quoted formula of words contained in an obiter dictum of Dickson J. in Moldowan v. R. (sub nom. Moldowan v. The Queen), [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213, which itself forms part of the definition of personal or living expenses in section 248. The respondent relies upon a passage from the examination for discovery of Mr. Feldgajer which he read into evidence during Mr. Feldgajer’s cross-examination:

117. Q. Was it your feeling that this, these investments, this additional capital was necessary in order to generate a profit from your business?

A. Yes. As I told you, I felt that I have to be fully 24 hours a day on this business to generate, not to become part time consultant.

118. Q. To generate a profit, you needed to be 24 hours, you needed to work?

A. Exactly. Exactly.

119. Q. When did you realize that, that it wasn’t sufficient to be part time to generate a profit? Approximately which year did that...?

A. Quite early. Around 1988, I realized that it’s very difficult to reach a lot of customers being full time employed with some other organization. And what I realized also is that I can put myself on every possible list and very possible data bank, computerized data bank, but it is still not generating enough income. So I have to bring more funds to be able to be fully 24 hours a day dedicated to this business. To bring more people in, and grow it. Even one fully dedicated person, it may not be enough to impress so many clients.

Based on these answers, counsel for the respondent argues essentially that the following sequence of reasoning should determine this issue.

(a) Mr. Feldgajer needed capital to permit him to devote his full time to the business.

(b) He could earn a profit only if he devoted his full time to the business.

(c) Therefore he did not expect to earn a profit and since the business was undercapitalized, it was, according to the obiter dictum in Moldowan, not a business.

In cross-examination Mr. Feldgajer qualified his answer by saying that with more capital he could earn more profit.

In any event, I think that the argument is a distortion of what the Supreme Court of Canada was saying. A business does not cease to be a business simply because it needs more capital.

Counsel for the respondent argues, as a corollary to the no reasonable expectation of profit point, that no business had commenced until it was fully capitalized and that did not happen until INM was incorporated.

I think that the business commenced when Mr, Feldgajer formed Feldgajer & Feldgajer Consultants. Business is broadly defined in section 248 and includes any commercial enterprise carried on with a profit motive, as this one unquestionably was. When a business is commenced is of course a question of fact (see Gartry v. R. (sub nom. Gartry v. Canada), [1994] 2 C.T.C. 2021, 94 D.T.C. 1947 (T.C.C.) at page 2025 (D.T.C. 1949); see also Griffin, Exp. Board of Trade, Re (1891), 60 L.J.Q.B. 235 (U.K. C.A.), per Lord Esher at page 237). A great deal of time was spent by Mr. Feldgajer in the years under appeal in seeking contacts and clients. It is true he was also seeking investors to put additional capital in the business but this in itself does not deprive his activity of the essential characteristics of a business. The revenues that he did earn can be described only as income from a business.

In Minister of National Revenue v. M.P. Drilling Ltd., [1976] C.T.C. 58, 76 D.T.C. 6028, the Federal Court of Appeal made a number of observations that are directly pertinent to the question involved here at page 62 (D.T.C. 6031-32):

As I understand it, it is basic to the appellant’s submissions that the expenditures incurred by the respondent in 1964, 1965 and 1966 were for the purpose of creating or acquiring a business structure. In appellant counsel’s submission its activities during those years were preparatory to or for the initiation of a business and were not outlays made for the purpose of gaining or producing income from a business. It this submission were accepted the payments would have been on account of capital, falling within paragraph (a) of Jackett, C.J.’s test propounded in the Canada Starch case, supra.

In my view this argument does not withstand scrutiny in that it ignores the fact that the business structure per se came into existence in late September when the respondent commenced its business operations by continuing the marketing negotiations, supply negotiations and technical studies through its consultants until June of 1964 when it opened its own office and engaged the services of its first employees, utilizing for such purposes funds advanced by its principal, Mr. Bawden, or other companies controlled by him.

It also ignores the fact that in the early summer of 1964 Mr. Van Wielingen joined the respondent as a full time general manager and chief operational officer. His duties at that time were according to his testimony, firstly, to develop a market for the product, secondly, to negotiate with actual and potential suppliers of liquid petroleum gases and, thirdly, to consider the technical aspects of production, storage, transportation and the like.

In short, the company was then in existence and was engaged in doing the normal things that any new business must do to bring its wares to the market place, hopefully with profitable results. As I see it, this business activity falls within paragraph (b) of Jackett C.J.’s test in the Canada Starch case, supra. Not to characterize such activity under this head is to ignore the commercial reality of the situation, which was that the respondent’s efforts at all times were directed to bring products it expected (by negotiation) to be able to acquire, to users who, through the promotional efforts of the respondent’s officers, indicated that they would be interested in becoming purchasers thereof. Negotiations proceeded with some twelve suppliers and the same number of potential foreign customers culminating in expressions of intent from some of each. The permanent structure, the market and the products all existed and the efforts of the respondent were directed to bringing them together with a resultant profit to it. The desired result was never accomplished and that part of the respondent’s business had to be abandoned although it continued in operation in the drilling business with profitable results. But the abandonment caused no transformation of the expenditures made in an effort to achieve profitability into expenditures capital in nature.

In my opinion, that argument is not supported by the evidence and, in fact, there is evidence which points in the opposite direction. Not the least important of that kind of evidence was the fact that negotiations undertaken by the respondent’s officers had culminated in some expressions of intent by potential customers to buy the gas and some by producers of the gas to sell it to the respondent for the purpose of resale. Quite clearly then, the respondent was in fact in business and was not simply bringing the business into existence.

It was then argued that there must be revenue before any deduction can be made for expenses which might otherwise properly be deductible as made for the purpose of earning income. I cannot agree that because the respondent had not generated any revenue, let alone profit, makes it any less “the process of operation of a profit making entity”. Nor does the fact that no revenues were generated from the activity transform what would have been deductible outlays for the purpose of gaining income, had there been any revenue, into expenditures made for the acquisition or creation of a business entity, or, to put it in the way earlier cases have put it, to bring into existence an asset or advantage of an enduring benefit of a trade (British Insulated and Helsby Cables v. Atherton, (1926) A.C. 205, [1925] All E.R. 623 (U.K. H.L.) at pages 213-14 (All E.R. 629).)

I should observe again that it was not suggested that the expenses were on capital account. So far as the existence of a “structure” is concerned, the structure needed to carry on a computer consulting business is far less elaborate than that needed for a drilling business. Such a structure requires the necessary computer equipment, an office, a telephone and, of course, a person possessing the requisite expertise and experience to provide the services sought by clients.

It is plain that what we have here is a brilliant entrepreneur embarking on an enterprise that entails certain risks because it is the leading edge of computer technology. Counsel suggested that I should draw some inference adverse to the appellant from the fact that neural networking, particularly in its application to pattern recognition, is a largely uncharted field and that therefore there was no business. It is unfortunate that an attempt to engage in a business in an advanced field of technology that is, by its nature, neither frivolous nor inherently incapable of producing a profit, should be discouraged by the Department of National Revenue simply because it is an enterprise that does not produce a profit in the first year. Not everyone who starts a business can be expected to hit the ground running. As Pigeon J. said in Freud v. Minister of National Revenue, [1969] S.C.R. 75, [1968] C.T.C. 438, 68 D.T.C. 5279, at page 80 (C.T.C. 441; D.T.C. 5281):

Fairness to the taxpayers requires us to be very careful to avoid allowing profits to be taxed as income but losses treated as on account of capital that therefore not deductible from income when the situation is essentially the same.

The appeal is allowed with costs and the assessments referred back to the Minister of National Revenue for reconsideration and reassessment to permit the deduction of the losses claimed.

Appeal allowed.