Karmin McKay v. Minister of National Revenue, [1993] 2 CTC 2740, 93 DTC 1064

Brulé, T.C.C.J.:—This appeal involves the appellant's 1982, 1983 and 1984 taxation years in which the Minister of National Revenue ("Minister") disallowed certain expenses claimed from underwater diving operations on the grounds that the taxpayer was not carrying on a business with a reasonable expectation of profit.

Facts

The appellant was at all relevant times an officer in the Canadian Army.

During the years in issue, the appellant explained that he may have been out of the country for approximately four months during the period under review. Given his full-time position as an army officer and his scuba diving activities, the appellant affirmed that he often worked 60 hours per week. The appellant emphasized that his spare time was spent in diving related activities and that during the years in issue it was often difficult to coordinate his diving activities with his work in the army given his frequent absence.

The appellant testified that he was initially involved in many areas relating to the scuba diving field such as training and instructing, as well as, the servicing, renting and selling of diving equipment. With respect to his qualifications in scuba diving, the appellant explained that he undertook various training courses relating to scuba diving and is considered a qualified scuba diving instructor.

During the course of trial, the appellant testified that his professional diving activities as a business began in 1981. He explained that by 1982 he had been posted in Fredericton, New Brunswick and that given the active diving community in the area and the absence of scuba diving instructors and suppliers of diving equipment, he attempted to establish a business in this field so as to serve the local divers in Fredericton. To this end, the appellant established the “Dragon Diving Specialties” ("Dragon").

In 1982 and 1983, the appellant explained that much of his time in the scuba diving field was limited to equipment sales and the publication of articles in journals as an expert in this area. However, the appellant submitted that by 1983, realizing the negative earning potential in diving instruction, he decided to begin some freelance underwater photography, a specialty in which he had published articles and completed courses in prior years.

Given the difficulty in maintaining and coordinating his military work and the scuba diving instruction business, the appellant explained that by 1984 he decided to narrow his scuba diving activities exclusively to underwater photojournalism. To this end, the appellant stressed that he refused to accept work which was not related to this area of specialty. The appellant stated that he had advertised for a business partner at this time but that no suitable offers had been forthcoming. He testified that the going rate per photograph was approximately $10 per slide. However, the appellant stated that in order to produce quality underwater photographs, specialist underwater camera equipment was required and therefore, substantial expenses were incurred in this regard.

During the cross-examination, the appellant conceded that he had no prior business expertise with respect to the running and operations of a business venture. Moreover, counsel for the respondent filed through the appellant copies of the appellant's 1982, 1983 and 1984 balance sheets and statements of income and expenses of Dragon for each of the taxation years in issue. The appellant admitted that during the 1981 to 1984 taxation years, he had shown the following gross income and expenses:

Moreover, the above balance sheets and statements revealed the following income amounts as resulting specifically from the sale of underwater photographs taken by the appellant for the respective taxation years:

Interestingly, the statements relating to 1984, the year in which the appellant testified that his concentration had switched entirely to underwater photography, indicate income in the areas of sales and rental equipment and instruction in the amounts of $1,225 and $440 respectively. Furthermore, camera equipment expenses of $6,407.34 are also outlined with a claim for depreciation over a three-year period. In prior years all amounts were expensed.

Although the appellant denied that he could not verify with proper vouchers the amount of expenses claimed, no documentation related thereto was filed with the Court during the course of the trial.

Finally, the appellant explained that between 1985 and 1987, his scuba diving activities involved solely the selling of underwater photographs and the publication of articles in relation to underwater photojournalism. Furthermore, the appellant admitted that the business did not result in a profit until the 1988 taxation year.

Issue

The sole issue in this appeal is whether the outlays or expenses incurred by the appellant in the 1982, 1983 and 1984 taxation years, in relation to the appellant's scuba diving activities, were incurred for the purpose of gaining or producing income from a business.

Income tax provisions

The respondent relies upon paragraphs 18(1)(a) and (h) and subsection 248(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act"). Paragraphs 18(1)(a) and (h) read, in the relevant taxation years, as follows:

18.(1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) General limitation. — an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

(h) Personal or living expenses. — personal or living expenses of the taxpayer except travelling expenses (including the entire amount expended for meals and lodging) incurred by the taxpayer while away from home in the course of carrying on his business;

Appellant's position

The appellant submitted that throughout the years in question and prior thereto he had attempted to develop his capabilities initially as a scuba diving instructor and later as an underwater photojournalist. The appellant argued that at all times his intentions were to make the diving field his profession for the purpose of earning income and making a profit. The appellant emphasized that the expenses incurred in respect of the scuba diving equipment and associated activities were for the purpose of gaining or producing income from a business with a view to making a profit. To this end, the appellant argued that in order to make the underwater photography business a success, good quality photographs were essential and consequently, expenditures in respect of specialty equipment were vital. The appellant contended that the losses at issue arose from outlays or expenses that were incurred for the purpose of gaining or producing income from a business carried on for profit. Consequently, the appellant submitted that the various expenses were properly deductible from his income as professional net losses in the relevant taxation years.

Respondent's position

Counsel for the respondent took the position that the expenditures claimed by the appellant were not outlays or expenses incurred for the purpose of gaining or producing income from a business carried on for profit or with a reasonable expectation of profit from the appellant's scuba diving activities.

The respondent conceded as a fact that the appellant had expertise in the underwater diving field; that he had written and published articles on the subject of scuba diving; that he had attended courses in respect of training in underwater diving and photography and that he expected to earn money from the various diving related activities. However, the respondent argued that the facts, as disclosed by the evidence before this Court, suggested that during the years in question, the appellant had no reasonable expectation of making a profit from a scuba diving venture. Therefore, counsel emphasized that the expenses claimed by the appellant were not incurred for the purpose of gaining or producing income from a business as outlined in paragraph 18(1)(a) of the Act but were personal or living expenses within the meaning of paragraph 18(1)(h) and subsection 248(1) of the Act.

During the argument, counsel for the respondent relied upon the Supreme Court of Canada decision in Moldowan v. The Queen, [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213, in discussing the constituent elements in the concept of reasonable expectation of profit" under the Act. In applying the various Criteria listed in that case to the facts at bar, counsel argued that the prerequisites as set out in Moldowan, supra, were not in fact present in the case before this Court.

Turning to the requisite factors set out in the above decision, counsel for the respondent submitted the following: First, with respect to the profit and loss experience in past years, it was noted that, in the taxation years at issue, losses were sustained in each of the three years such that the appellant's activities did not turn a profit during this time. Furthermore, counsel argued that the evidence suggested that the underwater photography venture did not demonstrate a potential to earn income. Second, with respect to the taxpayer's training, the appellant's viva voce evidence indicated that, although the appellant had extensive underwater diving and photography training, he had no business experience. In this regard, counsel emphasized that no business plan with projected profits, losses and expenses was prepared by the appellant prior to the years in issue. Third, counsel stated that the case at bar also failed to satisfy the future course of action test. In this regard, the appellant testified that his initial course of action involved training and instructing scuba diving and the servicing and renting of scuba diving equipment. This would cover the 1982 and 1983 taxation years given that the underwater photography activities did not commence until 1984. The respondent argued therefore, that at this time, the appellant's concerns were not one of profit-making but incomeearning. Finally, counsel for the respondent submitted that the appellant failed to demonstrate how he intended to make a profit from his alleged scuba diving activities. Counsel emphasized that the appellant's time was limited as he was a full-time Canadian Army officer. Furthermore, it was argued that the expenditures incurred by the appellant with respect to the camera and video equipment in the years in question did not show any relation to the earning of income from a business. In other words, counsel submitted that the appellant failed to demonstrate the capability of the venture as capitalized to show a profit.

Having reviewed the evidence for the Court, counsel for the respondent maintained that based on the facts and the relevant jurisprudence the appeal should be dismissed.

Analysis

Turning to the jurisprudence in this area, the case law suggests that to be considered a“ "business", the venture must be conducted for the purpose of making a profit or with the expectation of realizing a profit therefrom. (See Fleming v. M.N.R., [1987] 2 C.T.C. 2113, 87 D.T.C. 425 (T.C.C.).) In this respect, where a taxpayer incurs an expenditure for the purpose of earning income from a business, the taxpayer can deduct the amount expended as an expense regardless of whether or not the expenditure actually produced income. To be deductible an expenditure must have been incurred by the taxpayer in order to make a profit; it is not enough where the expense was incurred to earn gross income. (See Deputy Minister of Revenue (Que.) v. Lipson, [1979] I S.C.R. 833, [1979] C.T.C. 247.) Therefore the purpose of the expenditure is essential and must be analyzed such that where the taxpayer's primary purpose is to gain or produce income from a business in which the taxpayer is engaged then the amount is deductible. The determination of purpose is essential in ensuring that the taxpayer does not deduct amounts which are attributable to personal or living expenses which is prohibited under the Act. The taxpayer's credibility will undoubtedly play a vital role in assessing the purpose of an expenditure. Moreover, it is important to note that the purpose test is subjective and the courts will often examine the nature of the expense to assess whether it is of a type that is ordinarily and usually considered a direct expenditure in pursuit of a business or one that is personal and only slightly related to a business. Finally, the case law also suggests that for an expense to be deductible, there must be a reasonable proximity of the expense incurred to the profit made by the taxpayer from the business. In other words, the taxpayer must demonstrate how the expense relates to the expected profit. (See Symes v. Canada, [1991] 2 C.T.C. 1, 91 D.T.C. 5397 (F.C.A.).)

With respect to the burden of proof, the onus is upon the taxpayer to provide sufficient evidence to demonstrate that the taxpayer is operating a business. This was discussed in the case of Chequer v. The Queen, [1988] 1 C.T.C. 257, 88 D.T.C. 6169. At page 259 (D.T.C. 6170), Addy, J. had the following to say:

However, the plaintiff is obliged to go much further than demonstrate good faith. There exists a burden of proof on every taxpayer who claims a deduction of net losses resulting from a business adventure, to establish that there was, at the time that he engaged in and carried on with the business, a reasonable expectation of profit. The reasonableness of the expectation must be viewed objectively and cannot merely consist of an expectation which the taxpayer in good faith entertains to the effect that a profit will eventually be realized.

Consequently, the time and effort spent on the project, the quality of the work undertaken, or the background expertise are not determinative of the issue but rather, the extent to which these factors were likely to generate profits is the essential question. Such was discussed in Corrigan v. M.N.R., [1984] C.T.C. 2904, 84 D.T.C. 1764 (T.C.C.).

As indicated above, the distinction between personal and business expenses also relates to the reasonable expectation of profit by a taxpayer in conducting his activities. Expectation of profit is the central factor that differentiates a trade or business from the pursuit of a hobby. In this regard, the courts have held that subjective optimism does not in itself constitute a reasonable expectation of profit. (See /ssacharoff v. M.N.R., [1988] 1 C.T.C. 2006, 87 D.T.C. 673. (T.C.C.).) Unlike a business purpose test, a taxpayer's reasonable expectation of profit from an activity is determined on an objective basis by examining all the factors surrounding a business operation. The leading case in this area is the Supreme Court of Canada decision in Moldowan, supra. The Court stated, as per Dickson, J. (as he then was) at page 485-86 (C.T.C. 313-14; D.T.C. 5215):

There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. The following criteria should be considered, the profit and loss experience in past years, the taxpayer's training, the taxpayer's intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive. The factors will differ with the nature and extent of the undertaking:

Therefore, although Mr. Justice Dickson emphasized that there are criteria to be considered in determining the issue at bar, these factors are not determinative of the question in and of themselves and merely serve as a guideline. Consequently, the importance of a particular factor will vary in accordance with the nature and extent of the undertaking.

One further factor is of some significance. The larger costs incurred by the appellant in the acquisition of specialty camera and related equipment which he contended was vital for his underwater photography would not be considered as items to be expensed. Rather these would be capital in nature, further illustrating the appellant's lack of business knowledge and the workings of the Act. Only in 1984 was some equipment treated as capital and depreciation claimed.

Conclusion

In conclusion, the determination of whether or not a taxpayer has a reasonable expectation of profit is a question of fact. The volume of cases is of little guidance because each tends to depend on its own particular factual circumstances.

In the case at bar, I have no difficulty in finding that the appellant was a bona fide scuba diving specialist; that he had considerable expertise and experience in this field and that he had a desire to make money out of this venture. 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. Moreover, in light of the evidence, it does not appear that the venture was reasonably capable of turning a profit in future years.

In light of the leading case in Moldowan, supra, this Court must consider the profit and loss exemplified by the appellant's activities of prior years; the appellant's training and ualifications; the financial viability of the appellant's venture; and the stage of development of the undertaking in determining the issue at bar.

Notwithstanding the appellant’s best intentions, the requisite criteria set out in the Moldowan, supra, decision were not met by the facts proven in evidence before this Court. With respect to the business purpose test, the appellant's entire course of conduct during the relevant taxation years does not demonstrate that the expenditures were incurred with the primary purpose of gaining or producing income from a business. The appellant also failed to provide objective evidence to show that there was in fact a reasonable expectation of profit. Consequently, the losses incurred by the appellant during the taxation years in issue were personal or living expenses as defined in the Act.

The appeal is dismissed.

Appeal dismissed.