Dr. D.M. Karpiak Inc. And Dennis M. Karpiak v. Minister of National Revenue, [1991] 2 CTC 2702, 91 DTC 1446

Sobier, T.CJ.:—The appellant Dr. Dennis M. Karpiak ("Dr. Karpiak") appeals from the assessment of the respondent for his 1984, 1985, 1986, 1987 and 1988 taxation years, whereby the respondent:

(i) disallowed rental losses for those years from a condominium unit operated together with others as a hotel in Molokai, Hawaii, and

(ii) included in his income for the 1986 taxation year, as a shareholder benefit, certain travel expenses of Dr. Karpiak and his wife and certain unvouchered personal travel and entertainment expenses.

Dr. Karpiak also originally appealed the respondent's assessments disallowing an allowable business investment loss of $125,000 in his 1985 taxation year and disallowing a claim for scientific research tax credit in his 1984 taxation year.

A partial consent to judgment was filed with respect to those two issues.

In accordance with the partial consent to judgment, the appeal is allowed with respect to the allowable business investment loss of $125,000 in the 1985 taxation year and the assessment is referred back to the respondent for reconsideration and reassessment. The appeal with respect to the claim for scientific research tax credit in his 1984 taxation year is dismissed.

I will now deal with the remaining issues.

Dr. Karpiak is a successful medical practitioner in Kamloops, British Columbia, specializing in cardio-pulmonary medicine. He is the head of his department at the Kamloops Hospital. As well, Dr. Karpiak has established and operates a school of respiratory technology for the purpose of training technicians in the use of sophisticated respiratory equipment.

The other appellant, Dr. D.M. Karpiak Inc. (the "Company") was incorporated for the purpose of operating Dr. Karpiak's medical practice. Dr. Karpiak is an employee of the Company. The Company also employs a nurse/secretary on a full-time basis and Dr. Karpiak's wife, a registered nurse, on a part-time basis. The Company is 50 per cent owned by Dr. Karpiak, 30 per cent by his wife and 10 per cent each by his two children.

The Company appeals from the reassessment of the respondent disallowing certain travel and entertainment expenses.

I will deal first with the disallowed rental losses. Dr. Karpiak gave evidence that he previously had been involved in several real property investments. These included rental duplexes in Oshawa, Ontario, an investment known as Woodcroft Developments, where he bought four rental units and operated them profitably; and townhouses in Kamloops, British Columbia, which was an unsuccessful venture, subsequently taken over by the mortgagee.

Dr. Karpiak also had interests in real property in the United States. Among them were townhouses in Atlanta; Georgia, a partnership interest in a hotel in Houston, Texas; and an aborted development in Scottsdale, Arizona.

Dr. Karpiak stated that it was his practice to pay down the mortgages on his investments as soon as possible in order to reduce expenses and earn a profit.

Dealing with his investment in the condominium on Molokai, Dr. Karpiak stated that the project was developed by a limited partnership in which he was a limited partner. Upon completion, the project was rolled over to the original investors and Dr. Karpiak received one unit, namely unit 146.

The units were operated as a hotel. Some owners entered a rental pool whereby all of the rental income from the pooled units would be divided among the unit holders, regardless of which units were actually rented. Others received the rental income from their own units only. Dr. Karpiak had been in the rental pool for the most part. However, with new management taking over in 1989 the pooling concept was abandoned.

Prior to making the investment in 1981, Dr. Karpiak had been to Hawaii on four occasions, but not to the island of Molokai. In 1981, he spent one day on Molokai examining the proposed site of the project and discussing the investment with a representative of the developer. Dr. Karpiak was provided with a pro forma income and expense projection. The income projection was based on renting the units for 200 nights per year or approximately 55 per cent occupancy commencing in the first year. The statement contains a footnote indicating that occupancy and expenses were based on the 1980 occupancy and expense figures of the Sheraton Molokai, which was located opposite the proposed project, and Molokai Shores, located in the downtown area. Both of these hotels had been operating for some undisclosed time.

The pro forma statement indicated that, based on the assumptions made therein, a profit would be earned in the first year. The pro forma statement showed average annual net income per unit to be about $10,000. No provision was made for the interest expense on any money borrowed to finance the purchase of the unit nor was there any provision for capital cost allowance. The pro forma statement also assumed a ten per cent annual increase in revenues and expenses.

The issue revolves around whether Dr. Karpiak had a reasonable expectation of profit from the venture at the time of the investment and thereafter.

However, at this point, an examination of revenue and expenses would be in order. Actual revenues including personal use [1] were as follows for the 1984 to 1990 taxation years:

Based on the ten per cent annual increase indicated in the pro forma statement, income should have increased from about $20,000 in 1984 to $32,000 in 1989. Using the year with the largest gross revenue, that is 1988 with $15,062.47 rental income, there was still a shortfall of about $7,000.

Average per unit expenses in 1981 were estimated to be $3,600. Using the ten per cent annual increase, expenses in 1984 should have been about $4,800 before interest expense and capital cost allowance, when actually they were about $8,500 before interest expense and capital cost allowance.

Estimated and actual expenses before interest expense and capital cost allowance for the remaining years were as follows:

The purchase price for the unit was $175,000 of which $126,000 was financed by way of mortgages. The principal amount was reduced annually as follows:

The following are the rental losses determined by Dr. Karpiak in the 1983-1990 taxation years [2] which are after interest expense and capital cost allowance.

At the time of the making of the investment in 1981, did Dr. Karpiak have a reasonable expectation of profit from that investment? What steps did he take and what investigations did he make to come to the conclusion that there was a reasonable expectation of profit? Dr. Karpiak attended at the proposed site on one occasion, talked with the developer's representative, received the pro forma statement of income and expense and took it to his accountant with other unspecified information. This says Dr. Karpiak is sufficient, and to support that position he relies on Dr. Clare B. Baker v. M.N.R., [1987] 2 C.T.C. 2271; 87 D.T.C. 566 (T.C.C.). In Baker, the appellant purchased a semi-detached house in Florida. Although he was familiar with the area and knew that the houses in the development across the road were continually totally rented, Dr. Baker consulted his accountant who made the projections based on certain facts and concluded that if there was a minimum of 30 weeks' rental income, the excess would be profit. Dr. Baker relied heavily on the representations of a real estate agent that there would be no difficulty in renting the property and also upon representations as to what rents were reasonable in the circumstances. Based on this input, the accountant could determine where the point of profitability lay.

In the case at bar, all of the facts concerning the investment were provided by the agent for the developer. Dr. Baker did not have the experience which Dr. Karpiak possessed. Dr. Karpiak had been involved in many real estate investments. He suffered losses in some of them, and had to be aware of the risks of investing without proper investigations. In addition, there was no evidence as to exactly what the accountant had before him in making his assessment of the investment.

Given the pro forma statement and a debt of $120,000, Dr. Karpiak should have known that there could be no profit until interest expense was reduced or removed.

Dr. Karpiak argues that by paying down the mortgage, the property comes closer to realizing a profit. The graph below [not reproduced] sets out the profits or losses from 1984 to 1990 (1991 being an estimate). One should note that the mortgage was paid off in 1989.

Although there was a small loss in 1989 and a small profit in 1990, surely in 1981 this is not the sort of profit that one expects to earn in 1990 on an investment of $175,000 [3] .

Dr. Karpiak's position is not that there must be a certainty of profit, but a reasonable expectation of profit and refers to Ahluwalia v. M.N.R., [1987] 2 C.T.C. 2300; 87 D.T.C. 592 (T.C.C.). At page 2304 (D.T.C. 595), Judge Bonner refers to Clare , supra, and quotes a portion of the reasons of Chief Judge Couture as follows:

. . . a reasonable expectation of profit exists where given all the facts pertinent to a venture it could, within a realistic time (the period will vary depending on the nature of the operation), yield a profit barring abnormal circumstances. In other words, is the venture as structured and normally operated capable of generating a profit?

As structured, was this venture capable of generating a profit? I think not. After nine years the profit was $490 and this was before any provision for capital cost allowance. With the benefit of hindsight, we see year after year of losses. Yet, one must put oneself in the position of the investor at the time of the investment. What facts were there to support profitability at that time? The question has been answered before—little or none. Even if one were to say that, initially, he had a reasonable expectation of profit, Dr. Karpiak must have known, after a few years, that this expectation was incorrect. At that juncture, he would be hard pressed to say that the expectation remained.

The issue of capital cost allowance was raised in argument as were the reasons for judgment of Mr. Justice Dickson (as he then was) in Moldowan v. The Queen, [1977] C.T.C. 310; 77 D.T.C. 5213. At pages 313-14 (D.T.C. 5215), Dickson, J. made these remarks dealing with “reasonable expectation of profit":

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 ail 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: The Queen v. Matthews, [1974] C.T.C. 230; 74 D.T.C. 6193. One would not expect a farmer who purchased a productive going operation to suffer the same start-up losses as the man who begins a tree farm on raw land.

[Emphasis added].

Counsel for the appellant was invited to comment on the necessity of charging capital cost allowance. It was his opinion that it was optional for a taxpayer to charge capital cost allowance when calculating income for income tax purposes. That may well be for that particular purpose. However, what Dickson, J. said was that in examining the question of reasonable expectation of profit, profitability must be determined after charging capital cost allowance.

For all the above reasons, the appeals in connection with rental losses for the 1984, 1985, 1986, 1987 and 1988 taxation years are dismissed.

I will now deal with the appeal of the Company with respect to the disallowed expenses on the trip to Singapore and with the other disallowed travel and entertainment expenses. The reverse of this issue involves including in Dr. Karpiak's income the amounts of any benefits conferred upon him by the Company as shareholder benefits under subsection 15(1) of the Income Tax Act, R.S.C. 1952, c. 148 (am. S.C. 1970-71-72, c. 63) (the "Act").

In the fall of 1986, Dr. Karpiak and his wife attended the XXVIth IUAT World Conference in Singapore together with other members of the Canadian Lung Association. The travel arrangements were made so that the delegation could travel on a group package. It was Dr. Karpiak's evidence that the package was designed to provide for the least expensive way of travelling to Singapore. The trip started in Vancouver, thence to Los Angeles, Tokyo and Hong Kong and finally to Singapore. Alter the conference, Dr. Karpiak and Mrs. Karpiak travelled to Bali in Indonesia. They returned to Vancouver via San Francisco. In issue are the amounts claimed as business expenses for stopovers in Tokyo and Hong Kong. Also in dispute were expenses for travellers cheques amounting to $1,285.

Separate and apart from the conference expenses was the cost of two airline tickets purchased in January of 1987, and certain restaurant expenses incurred during the period of May 1986 to January 1987, totalling $2,791.50.

The respondent was prepared to allow expenses incurred for a one night stopover in Tokyo. Dr. Karpiak's evidence was that there was a late night arrival in Tokyo when he and the other travellers immediately went to bed. Accordingly, the next day was necessary to refresh oneself from the long trip from Vancouver. On the other hand, the side trip to the Japanese Country Inn was an extra and not necessary for the stopover and not related to the Conference. However, since the package tour included a stop in Hong Kong it would have been impossible not to be there. Therefore, the hotel and meal expenses incurred on the Hong Kong stopover are allowed.

Expenses incurred in connection with travellers cheques amounting to $1,285 were disallowed by Revenue Canada since Dr. Karpiak could not establish their purpose and at the hearing of the appeal, he still could not explain their purpose.

Similarly, unvouchered restaurant expenses were disallowed in the amount of $2,791.50. Dr. Karpiak was unsure for what purpose these expenses were incurred. There was some evidence that he travelled to Vancouver to meet with lawyers and accountants. However, Dr. Karpiak could not establish who, where and for what purposes the expenses were incurred.

A party for members of the Kamloops Hospital staff was provided by the Company. Since they were not the Company's employees, suppliers, patients or referring doctors, the expenses were not established as having been incurred for the purpose of earning income.

Dr. Karpiak admitted that it was possible that the two airline tickets purchased in January 1987 amounting to $831.60 might have been used to travel to Hawaii and therefore are of a personal nature.

The Company was unable to discharge the onus of rebutting the respondent's assessments concerning these expenses.

The next issue is whether the benefits received by Dr. Karpiak were conferred upon him under subsection 15(1) of the Act as shareholder benefits or under paragraph 6(1)(a) of the Act as employee benefits. If they can be charac- terized as employee benefits, they would be deductible in computing the income of the Company.

In order for the Company or Dr. Karpiak to claim that the amounts received were paid as employee benefits, Dr. Karpiak would have to justify to the Company that the expenses were ones which benefitted the Company in order that the Company could in turn satisfy the Court that the expenses were made for the purpose of earning income. Neither the Company nor Dr. Karpiak have been able to show what benefit the Company received or for what business purpose the expenditures were made. Therefore, not having established that the expenses were employee benefits, the Company cannot deduct the amounts as such. Even if the Company were willing to accept that the amounts were either direct expenses or employee benefits, and pay them, it does not follow that they are deductible. The Company must still satisfy the Court that they were in fact expended for the purpose of earning income. This has not been done.

Therefore, for the above reasons, the appeal of the Company is allowed, without costs, to the extent only that the two nights' stopover expenses incurred in Tokyo (not including the cost of the Japanese Country Inn) and the expenses of the Hong Kong stopover were deductible expenses and the assessments referred back to the respondent for reconsideration and reassessment on that basis. In all other respects the appeals are dismissed.

Appeals allowed in part.