George Knight v. Minister of National Revenue, [1993] 2 CTC 2975, 93 DTC 1255

Mogan, T.C.C.J.:— In computing his income for 1986 and 1987, the appellant deducted the amounts of $12,500 and $67,761 respectively as losses suffered in the operation of a business which he owned. The Minister of National Revenue disallowed the deduction of those losses. The basic issue in these appeals is whether the appellant was carrying on a business during 1986 and 1987 in respect of which the losses were deducted. There is a secondary issue concerning the value of certain machines which the appellant owned on July 1, 1986.

The appellant is by profession a school teacher. He started teaching in a one-room rural school in 1964 and attended university courses in the evening. He earned an honours B.A. in geography and history and a Masters in Education. The appellant has always had an interest in machines which could work on metal. Around 1971, he started to acquire the kind of machines which one would ordinarily find in a machine shop. This was a hobby at the time and he generally purchased used machines. He lives on one acre of land on the north side of Big Island on the Bay of Quinte about 20 miles south and east of Belleville, Ontario. He built a machine shop on his land behind his house. Over a period of years, he acquired machines having an aggregate cost to him of approximately $200,000.

The appellant took evening courses in machine shop which permitted him to acquire a teaching certificate in machine shop at the high school level. He is also qualified to teach auto mechanics and woodworking. He has a motor mechanic's licence and is qualified to be head of a technical department in an Ontario high school. In 1982, he started teaching technical subjects when employed by the Lennox and Addington County Board of Education. The appellant took leave of absence from his teaching employment throughout the school year 1986-87. The purpose of the leave is expressed in his own words: "I took the year ‘86-87 off to get the business going”. There is no question that the appellant was not engaged in any business prior to 1986 because of the statement quoted above and the following statements in paragraph 3 of his 1987 notice of appeal:

3. In 1986, the appellant commenced the business of developing prototypes of, subsequently producing, and maintaining, machine tools to be used in connection with computer applications software. Such business was carried on at Bi Island in the Bay of Quinte region under the name “North Shore Auto and Machine”.

The first issue in this appeal is whether the appellant was carrying on a business during the last half of 1986 and in 1987. In the early 1970s, the appellant was working on a wind-generating project, making the airfoils for a windmill. He concluded that the blades designed at that time were for power as in an aircraft and not for generating purposes as in a windmill. The machines used to build blades for the aircraft industry were very expensive. What the appellant needed was a less expensive machine which was software driven to build windmill blades. His work on windmill blades got sidetracked when he discovered that the controls he was using could also be used for the software control of machine tools.

The appellant thought that he could take existing machine tools like the ones in his own shop and, by removing worn parts and applying new controls, convert them into computer operated machines. His objective was to reduce the cost of production in small machine shops through the use of less expensive but efficient computer-controlled machines. He was trying to develop a software control that was easy to learn and use and quick to program. The appellant knew that small machine shop operators tended to be older and probably not literate in computers. His idea was to develop a software control that a person could learn to use in less than a day. There were already on the market computer controls for very large and expensive machines but the appellant was looking at the other end of the market where there were few computer-controlled machines available.

The appellant was not attempting to manufacture the machine or the computer. He was developing the software and marrying the computer to the machine to do by computer what had previously been done by hand. In the fall of 1986, when the appellant started his sabbatical year, he decided to devote all of his time and attention to what had been his hobby in order to turn it into a business. At the time, his shop was fully equipped to do this. In his examination-in-chief, he described his objectives as follows (transcript pages

Q. Now, what made you decide to turn your hobby into a business?

A. I felt at the time the technology was available. I felt the need was here. We were approaching a point where Canada was not as competitive and I really felt that, as people were moving from the cities, we had a good opportunity to provide a technology that would find a ready market. As well, schools were ready for computer-controlled machinery.

Q. Did you think you could make a profit in doing this?

A. Yes, I did.

Q. What did you think you could make to sell?

A. I felt, originally, we would retrofit an existing machine; that is, take an existing machine and computerize it. That would mean that we could save this machine from scrap, renew it and ive it life. That was our original thought. It has turned out that labour costs being what they are, it's probably more cost-effective and a better product to start with a new machine.

Q. What is your proposal now? You buy a machine and buy a computer?

A. We buy a new machine which is ready to be computer-controlled. We buy a computer control, add our software and the hardware that we obtain — design and obtain in some cases — and marry them together.

Q. At the time you started this in ‘86, you were taking a sabbatical from teaching, although you were doing some work at Queen's?

A. That's correct.

Q. You finished your sabbatical and went back to teaching at that point?

A. I did.

Q. Why is that?

A. Things hadn't gone quite as quickly as I had hoped. The software hadn't developed as fast as I had hoped. We just weren't ready. And I went back to work on the software design and develop some more money for another try at it.

The appellant went back to full-time teaching in the fall of 1987 and continued until May 1, 1990 when the teachers employed by his school board went on strike. At that time he left teaching to renew full-time efforts at his machine shop. During the time he was back teaching, he continued his efforts to develop his business and described his activities as follows (transcript pages 27-28):

Q. From the period from the fall of'87 until 1990, you're still teaching and you're trying to develop the business?

A. That's correct.

Q. How much time would you be spending during this period of time in your business?

A. Evenings and weekends, probably approaching 40, 50 hours, all told [sic: per week],

Q. Are you spending most of the weekend at it?

A. Yes. During that time, one of our ventures had — my associate was in Washington, D.C., so I was driving from my teaching position down to Washington, working the weekend and then coming back, taking the information from my weekend and getting ready for the next weekend's work.

Q. You could work away from the shop?

A. Yes. It's developing software; so it's — in this case, it was developing the design for the software.

The inference which I draw from the appellant's last answer is that, during the period from September 1987 to April 1990 when he was employed as a full time teacher, he was still “developing the design for the software”. In other words, during that period he had not completed the development of the software which was an essential element for his smaller computer-controlled machines. Without the software, he had no product to sell. This is borne out by the financial statements (Exhibits R-1 and R-2) which he filed with his income tax returns for 1986 and 1987 with respect to the business he was attempting to start under the name “North Shore Auto and Machine”. Those financial statements show the following entries:

1986

Sales, Gross Revenue		Nil
Capital Cost Allowance	($12,500.00)
Loss	$ 12,500.00
1987
Sales, Gross Revenue		Nil
Expenses:
Automobile	$	719.89
Insurance		472.35
Repairs and maintenance		11,380.32
Office expenses		578.41

Property taxes	396.00
Space rental	300.00
Shop expenses	763.72
Equipment leasing	4,900.00
Capital Cost Allowance	48,250.00
Loss	$ 67,760.69

There was also entered as Exhibit R-3 the 1988 financial statement of North Shore Auto and Machine which showed the following entries:

1988

Sales, Gross Revenue		Nil
Expenses:
Accounting	$	195.00
Insurance		517.00
Light, heat, water		488.37
Office expenses		272.40
Property taxes		410.44
Space rental		300.00
Capital Cost Allowance		39,275.00
Loss		41,458.21

It is significant in the above financial information that there were no sales and no revenues of any kind in the years 1986, 1987 or 1988. If there were no sales, there were no customers. And if there were no customers, one has to question whether there was any business to carry on. It appears that the appellant took time off from teaching in 1986-87 to devote all of his time and energy to his hobby before he had developed any product which could be offered for sale in a commercial sense. This is confirmed by his further statements (transcript page 31):

Originally, I thought we probably could have something on the market by the fall of ‘ 87, maybe not too well-developed. That proved very quickly not to be possible; so I worked by myself and looking at technology, and it wasn't until really the summer, I guess, of'89 where I met a chap who had some ideas and who had some of this work — he was working in parallel with me — that we were able to combine and find a product that seemed to make sense.

The appellant did not demonstrate any machines prior to the spring of 1990 and acknowledged in 1992 that he still had a little software to do. On May 2, 1991, the appellant signed a contract with the London and Middlesex County Roman Catholic School Board for $19,500 to provide a milling machine for a high school. He was not able to fulfill the contract because the system he was using did not have CSA approval and it was not quite ready to be released. When asked by his own counsel why he was soliciting orders when he did not yet have a machine that worked, the appellant answered: “I guess we were just a little too optimistic.” Even at the time of hearing this appeal in 1992, the appellant did not have a saleable product as indicated in his following answers (transcript page 44):

Q. It’s obvious over this period of time that it's taken you longer than you anticipated?

A. That's correct.

Q. You have not yet got to the point where you've got something that’s saleable?

A. Almost.

Q. You're still confident that you have a viable product, something that you can put on the market?

A. Yes, I do.

Q. What's the next step? What has to be done yet?

A. At this particular time, we have three people working under contract to us. Unfortunately, one just got married and, when he gets back next week, he has about a week's work to put a 2D program, an end-to-end 2D program, in place. We should be testing it, I think, by the end of next week, if all goes well.

Q. Do you have any test products out there? Is anybody using these test products?

A. We have the ones in the shop that work after a fashion.

When the appellant went on sabbatical in the fall of 1986, and throughout 1987 (even after September when he went back to full-time teaching), he was still in the development stage of his proposed business. In cross-examination, he gave the following answers (transcript pages 88 and 90):

Q.. . . what was your intention when you left on leave? Was it to be only on leave from ‘86 to the spring of ‘87?

A. My intention was . . . I felt I could start a business at that time. That was my intention.

Q. Okay. But that intention was frustrated, I take it?

A. I was not far enough along. . . the technology was not far enough along for me to feel that I had a reasonable chance of income.

Q. You had to go back to school because you were not financially in a position to continue on with this business?

A. The technology was not at a place where it made sense to do it that year, yes.

Q. Right. So you decided to go back to school?

A. That's right.

Counsel for the appellant argued strongly that his client had a genuine intention to be in business and that his intention was proven by his commitment of time (he took a sabbatical year from full-time teaching) and his commitment of capital (he had accumulated machinery costing approximately $200,000 for his hobby as a machinist before attempting to convert the hobby into a business). Also, the appellant had extensive training, education and experience as a machinist. I am satisfied that the appellant did have a genuine intention to be in business at some time but I question whether he was carrying on any business in 1986 or 1987.

The appellant was like any amateur inventor who has a good idea but has not yet ironed out all the wrinkles to make his idea commercially viable. Until he has something to take to the market, he is still only an amateur inventor developing his idea or product. During 1986 and 1987, he had no product to sell. He had no customers. He had no sales or revenue of any kind. He could not and did not advertise. There was no trading. In summary, there was no commerce or business.

This is not like an existing business making sales to the public but operating at a loss because it needs a start-up period to develop enough customers to become profitable. In the appellant's situation during 1986 and 1987, he could not open his door to the public and could not make any sales because he had no product to sell. Even four years later in 1991, when he signed a contract with a school board to provide a milling machine for $19,500, he was unable to fulfill the contract because his process did not have CSA approval. Although the appellant had a real intention to be in business and a clear concept of what his business would be, and although he made a significant commitment of time and capital to that intention and concept, I have concluded that his proposed business was still in the development stage in 1986 and 1987.

Many analogies are not appropriate but I would make this comparison. For a mining corporation, exploration and development must precede the com- mercial activity of mining. It has been held that development is the preparation of the deposit or mining site for actual mining (International Nickel Co. v. M.N.R., [1971] C.T.C. 604, 71 D.T.C. 5332 (F.C.T.D.) at pages 625-26 (D.T.C. 5345)). In my opinion, the appellant was in 1986 and 1987 still engaged in the preparation of his product for the actual business of production and sale. He was still in the development stage.

Counsel for both parties cited authorities on the question of whether a business is carried on with a reasonable expectation of profit. Mr. Carr referred to the well known statement of Dickson, J. (as he then was) in Moldowan v. The Queen, [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213 at page 485 (C.T.C. 313, D.T.C. 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: Dorfman v. M.N.R., [1972] C.T.C. 151, 72 D.T.C. 6131 (F.C.T.D.). See also paragraph 139(1)(ae) [now subsection 248(1)] of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the"Act") which includes as" personal and living expenses" and therefore not deductible for tax purposes, the expenses of properties maintained by the tax- pe for his own use and benefit, and not maintained in connection with a ess carried on for profit or with a reasonable expectation of profit.

Applying that statement from Moldowan to the facts herein, the appellant certainly did not have a profit from his purported business in 1986 or 1987. And in my opinion, the appellant did not have any reasonable expectation of profit because he had nothing to sell in those years. His financial statements show not one tiny particle of revenue but only expenses. And among his expenses, there is no outlay for advertising. There was no evidence that the appellant made any attempt to solicit customers during 1986 or 1987, an indication that the appellant himself realized that he had no product or service to provide in those years.

In Garden Investments Ltd. v. M.N.R., [1974] C.T.C. 2013, 74 D.T.C. 1014 (T.R.B.), the issue was whether the taxpayer corporation had ceased carrying on business for a few years and then started up again attempting to carry forward prior losses. The learned chairman of the Tax Review Board (K.A. Flanigan, Q.C.) stated at page 2016 (D.T.C. 1016):

. . . then by no stretch of the imagination can l find that this company was carrying on business in the period that I have outlined, because it had nothing to sell, it had nothing to rent, and nothing with which to produce profit or improvement for itself, because it had disposed of all its assets.

Although the appellant had acquired many different machines during his hobby" years from 1971 to 1985 and had not disposed of those machines, his ongoing research and attempts to develop the appropriate software to link a computer control with an operating machine covered the period from 1986 through to 1989 or 1990. Research and experiment are essential in the development of any new product but, standing alone, they do not comprise the carrying on of a business. Because the appellant was not engaged in any other commercial endeavour in which he was attempting to sell and ready to deliver any product or service to the public, he had no possibility of earning any revenue. If there was no possibility of revenue, there was no possibility of profit. And of course, if there was no possibility of profit, then there was no reasonable expectation of profit.

I return to the above uoted words from Moldowan. To have a source of income, a taxpayer must have a profit or a reasonable expectation of profit. Source of income, therefore, is an equivalent term to business. If a taxpayer does not have a profit or a reasonable expectation of profit, then he does not have a source of income. And if he does not have a source of income, he does not have a business. The appellant did not have a business in 1986 or 1987. Therefore, he was not carrying on any business in 1986 or 1987 in respect of which he could incur a loss which would be deductible in computing income for purposes of the Income Tax Act. Having concluded that the appellant did not have a business in 1986, it is not necessary for me to determine which machines he purported to transfer from his hobby to his business in July 1986 or the fair market value of those machines at that time.

This is the kind of appeal which one would like to allow because Canada needs persons like the appellant who have inventive skills and are prepared to take the risk of leaving secure employment to attempt to start a business. The appellants forthright and candid testimony, quoted at length above, is a clear indication to me that, during 1986 and 1987, he was engaged only in research, experiment and development. Unfortunately, I cannot persuade myself that the appellant had a product to sell in 1986 or 1987 or that he had a business to carry on or operate in those years. For the reasons given above, the appeals are dismissed.

Appeals dismissed.