Virtue v. R., [1998] 1 CTC 2910

Rowe D.J.T.C. .

The parties agreed the two appeals would be heard on common evidence. The appellants are partners, operating as K2V2 Amusements (K2V2), and in each of the 1993 and 1994 taxation years, each appellant deducted certain amounts as business losses which the Minister of National Revenue (the “Minister”), by reassessment, disallowed on the basis neither appellant had any reasonable expectation of profit from the activity in the years under appeal.

By agreement, the following exhibits were entered:

Exhibit A-l - Income and Expense summary of K2V2 — 1990-1994

Exhibit A-2 - Income and Expense statement of K2V2 — 1995

Exhibit A-3 - Statement of Business Activities of K2V2 — 1996

The appellant, James Virtue, testified he is a teacher, living in Regina, Saskatchewan, and formed a 50-50 partnership with his father-in-law, Edward Kryski, to operate K2 V2, a business involved in leasing amusement games to arcades, restaurants and other locations. In 1984, they purchased part of an existing business which had been operating in Regina leasing out video games. He stated he borrowed the sum of $30,000 from the Teachers’ Credit Union and the previous owner was paid $25,000 and the balance was used to purchase new video games. He explained it was necessary to have top equipment during the 1980’s and some of the games were located at the University of Regina and at Luther College. Others were placed in bars and confectioneries. By 1989, K2V2 had games situated in 12 locations, most of which were in Regina or in communities within 1 hour travel by car. In 1988, the partnership undertook a major expansion and went into an arcade on Dewdney Avenue in Regina. K2V2 had placed games in a laundromat in a commercial centre but the owners of the building proposed an arrangement whereby a renovation would be done and K2V2 would supply 40 games to the enlarged arcade. The operator wanted K2V2 to take over the entire complex and since Kryski was retiring that year from his employment, they incorporated a company, Velkor Holdings Ltd. (Velkor), and used it to lease the laundromat, gas bar, and confectionery totalling 4,000 square feet. When K2V2 had placed the machines in the arcade, the owner/operator of the business split revenue from the machines with the partnership on a 50-50 basis. However, shortly after taking over the larger space with the other commercial activities, the revenue from the arcade operation fell to 25% of the previous level. The arcade - known as Fast Eddie’s - had been the “hot place in town” but the location became subject of a dispute over “turf’ involving teenagers and soon the police had to be called frequently and other paying customers began to avoid the place. Velkor retained 100% of revenue generated by the games and at the end of the year when Velkor did not renew the lease on the complex the previous owner took over the operation and K2V2 again received revenue from the games on the basis of the 50-50 split. During this phase of the business involving himself and Kryski, he borrowed more money from the Teachers’ Credit Union and Kryski took out a second mortgage in the sum of $28,000. The partnership now was paying interest on more than $100,000. Velkor also borrowed money and they guaranteed the debt. In 1990, K2V2 paid the sum of $13,062.37 in interest. Due to repayment on the principal and falling interest rates, the amount of interest paid in 1994 was $6,647.07. Virtue explained that, after 1990, K2V2 moved away from relying exclusively on video games because the number of good locations had decreased. As a result, the partnership began purchasing pool tables and Foosball and pinball games which have a longer lifespan and could be sold later to persons wanting these machines or tables in their own homes for private recreational use. The video games were producing less than 50% of total partnership revenue and since he and Kryski had exhausted their borrowing power, they used their own savings to purchase additional equipment. The amount of maintenance required on the machines became less and they started to do custom work for other games operators, repairing equipment and doing service work on a fee-for-service basis. Kryski had retired and was able to devote much of his time to this aspect of the business. In 1996, service work produced revenue in the sum of $14,779 and K2V2 produced a profit of $960 on total revenue of $45,353. However, he estimated 1997 will probably be no better than a break-even proposition because two of the businesses in which machines had been located went bankrupt and the machines had to be relocated. Virtue stated during the 1993 and 1994 taxation years, he spent 15-25 hours per week on the business and explained the fall season is extremely busy as machines are moved from summer locations to winter placements. During other times of year, he estimated he spends a minimum of 10 hours per week on service calls. He stated the pool tables owned by K2V2 are coin-operated and have a lifespan of 10 years or more. As a result, maintenance costs are less than with video games or pinball machines and there is an after-market, even to competitors. Virtue stated the truck was purchased solely for the purpose of moving the games and equipment owned by K2V2. Kryski had been using his own vehicle - an old Buick - to do service work but it was expensive to operate and so the partnership borrowed $9,000 to purchase a 1991 Chrysler Lebaron. The full purchase price was $14,000 but Kryski traded in the Buick and put in some of his own money. During 1993, Virtue stated he used his own vehicle to make business trips and charged the sum of 10 cents per kilometre. One of the trips was to West Edmonton Mall which is the site of the largest and newest equipment in the industry. In addition, he visited Pacific Vending in Vancouver which is a major supplier of games. Virtue stated neither he nor Kryski ever attended trade shows in Las Vegas, New Orleans or other locations in the United States. K2V2 purchased machines from three suppliers and obtained some parts from Montreal. While in the Lower Mainland in British Columbia, he visited arcades in order to see what was the latest in games being offered to the public. He also travelled to Penticton, British Columbia to inspect a video arcade which had been for sale and had good equipment but after looking at the situation decided against any purchase by K2V2. Because his family accompanied him on the trips to Edmonton and to the Vancouver area, he charged only 10 cents per kilometre for business purposes instead of 30 cents which would more accurately reflect the cost of operating the vehicle. In operating the partnership, Virtue stated no salaries were paid to outsiders and friends were often asked to help move pool tables and other equipment from one location to another.

In cross-examination, he agreed the partnership had income and expenses for the years 1987 to 1994, inclusive, as set out at paragraph 9(e) of the Reply to Notice of Appeal and that a loss had been incurred in each of those years. He denied the validity of the assumption of the Minister at paragraph 9(g) of the Reply and stated he had completed a form in which he indicated revenue of the partnership was under $30,000 for purposes of exemption from collecting and remitting GST. He agreed the sum of $30,000 in annual income was not sufficient to service debt and pay all the other expenses involved in operating the business even without including Capital Cost Allowance. He explained the accumulated home office expenses related to use of a large garage at Kryski’s residence to store, service and repair machines and equipment. He stated he and Kryski were aware the partnership would not produce a profit during 1993 and/or 1994 but they were building up assets which had a resale value of $50,000 or $60,000 depending on the method used to sell the assets but pointed out the value might be as low as $5,000 at a liquidation auction,

In re-examination, Virtue stated it is necessary to remain current as young people want to play the latest game. Some versions may be interesting to customers for three or four years while others may last less than one. He believed the market for used coin-operated pool tables would support sales within a price range of $2,500 to $3,000.

Edward Kryski testified he retired after 30 years employment as a public servant with the Government of Saskatchewan, is 66 years old and earns income from his pensions. He stated he is a partner in K2V2 and works between 40 and 60 hours per week in the business. He does collections on a weekly basis, one of which involves a three-hour return trip, and does service work, mostly during the evening. He uses a workshop in the garage at his residence to repair machines and it is so crowded he is not able to use it to store his own car. The shop is heated electrically and there is another attached building which is also used for storage. Overflow storage is accomplished by putting equipment in the garage at Virtue’s residence, for which there has never been any charge to the business. The 1986 Dodge Truck is used for business and 99% of the time the Lebaron is used for business, as well. Mrs. Kryski does not drive a vehicle and they live less than one block from a mall and their daughter - James Virtue’s wife - drives her around, as needed.

Counsel for the appellants submitted they should be entitled to deduct their losses as there was no personal element to their activities and the bad experience in 1988 and 1989 created a large interest expense which seriously affected the business thereafter. The large amount of debt incurred at the time impaired the ability of the business to expand and caused the partnership to pay out large sums each year in interest. Counsel submitted the partners could show a profit upon disposition of assets by way of recapturing CCA and the Minister would be entitled to tax thereon.

Counsel for the respondent submitted there was no reasonable expectation of profit within the context of the relevant jurisprudence.

In Tonn v. R. (1995), 96 D.T.C. 6001 (Fed. C.A.) , the Federal Court of Appeal examined the concept of reasonable expectation of profit as it has evolved over the years since the judgment of the Supreme Court of Canada in Moldowan v. R., [1978] 1 S.C.R. 480 (S.C.C.). In the case of Zonn, supra, Linden, J.A., writing for the Court, undertook an analysis of the case law and at p. 6009 stated:

A closer look at this jurisprudence will illustrate that this is the approach now taken in most of the cases. The cases in which the “reasonable expectation of profit” test is employed can be placed in two groups. One group is comprised of the cases where the impugned activity has a strong personal element. These are the personal benefit and hobby type cases where a taxpayer has invested money into an activity from which that taxpayer derives personal satisfaction or psychological benefit. Such activities have included horse farms, Hawaii and Florida condominium rentals, ski chalet rentals, yacht operations, dog kennel operations, and so forth. Though these activities may in some ways be operated as businesses, the cases have generally found the main goal to be personal. Any desire for profit in such contexts is no more than a “pious wish” or “fanciful dream”. It is only a secondary motive for having set out on the venture. What is really going on here is that the taxpayer is seeking a tax subsidy by deducting the cost of what, in reality, is a personal expenditure.

In the within appeals, there is no such personal element applying to either appellant. The case must, therefore, turn on whether the enterprise, purely commercial in nature, meets the business test. The appellants, operating the partnership K2V2, increased revenue from $57,170 in 1987 to $309,311 in 1988 as a result of taking over the entire complex in which they had formerly placed machines within one portion. In 1989, they did not renew the lease on the larger operation and returned to the traditional method of gaining revenue by placing machines in other businesses and splitting the take on a 50-50 basis. It was that expansion in taking over the entire arcade and other business activities which led to an increased debt. The partners financed the purchase of additional equipment and, until the location developed problems by reason of being the central issue in a territorial dispute among young people, it had been doing well with the potential to produce significant revenue. After the troubles occurred on the arcade premises, the revenue fell by 75% at a time when costs had increased to handle the expanded revenue base. Then, the interest on money borrowed caused a heavy burden to be borne by their business which had reverted, in 1989, to the ordinary method of producing revenue which resulted in gross income of $42,197. The difficulty lay in slowly reducing the debt and the interest thereon which process was assisted by reduced rates.

In the recent decision, unreported, of the Federal Court of Appeal in Mastri v. R., A-650-96, dated June 27, 1997, Robertson, J.A., [reported (1997), 216 N.R. 74 (Fed. C.A.)] writing for the Court, dealt with the issue of whether or not there had been a misapprehension by the Tax Court of the true import of Tonn, supra. At p. 6 of his reasons, Robertson, J.A. stated:

First, it was decided in Moldowan that in order to have a source of income a taxpayer must have a reasonable expectation of profit. Second, “whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts” (supra at 485-86). If as a matter of fact a taxpayer is found not to have a reasonable expectation of profit then there is no source of income and, therefore, no basis upon which the taxpayer is able to calculate a rental loss. There is no doubt that, post-Moldowan, this Court has followed and applied that decision: see Landry v. Canada, 94 DTC 6624; Poetker v. Canada, 95 DTC 5614; and Hugill v. Canada, 95 DTC 5311. The only remaining issue is whether Tonn departs from that jurisprudence by postulating that the reasonable expectation of profit test remains irrelevant to the question of deductibility of losses until such time as it can be established that the case involves an inappropriate deduction of tax, the presence of a strong personal element or suspicious circumstances. There are two passages in Tonn which are cited in support of that proposition of law and are worthy of reproduction (supra at 6009 and 6013):

The Moldowan test, thereofre is a useful tool by which the tax-inap- propriateness of an activity may be reasonably inferred when other, more direct forms of evidence are lacking. Consequently, when the circumstances do not admit of any suspicion that a business loss was made for a personal or non-business motive, the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgment may have been less than competent.

...I otherwise agree that the Moldowan test should be applied sparingly where a taxpayer’s “business judgment” is involved, where no personal element is in evidence, and where the extent of the deductions claimed are not on their face questionable. However, where circumstances suggest that a personal or other-than-business motivation existed, or where the expectation of profit was so unreasonable as to raise a suspicion, the taxpayer will be called upon to justify objectively that the operation was in fact a business. Suspicious circumstances, therefore, will more often lead to closer scrutiny than those that are in no way suspect.

In my respectful view, neither of the above passages support the legal proposition espoused by both the Minister and the taxpayers. It is simply unreasonable to posit that the Court intended to establish a rule of law to the effect that, even though there was no reasonable expectation of profit, losses are deductible from other income sources unless, for example, the income earning activity involved a personal element. The reference to the Moldowan test being applied “sparingly” is not intended as a rule of law, but as a common-sense guideline for the judges of the Tax Court. In other words, the term “sparingly” was meant to convey the understanding that in cases, for example, where there is no personal element the judge should apply the reasonable expectation of profit test less assiduously than he or she might do if such a factor were present. It is in this sense that the Court in Tonn cautioned against “second-guessing” the business decisions of. taxpayers. Lest there be any doubt on this point, one need go no further than the analysis pursued by the Court in Tonn.

In Tonn, the Court clearly held that no personal advantage had accrued to the taxpayer who was seeking to deduct rental losses from his other sources of income. Nonetheless, the Court continued to pursue the deductibility of losses issue by applying the factors set out in Moldowan when assessing whether there was a reasonable expectation of profit. The Court’s summary, provided at 6015, lays to rest any doubt as to what was decided in Tonn\

My disposition of this case is therefore as follows. The Tax Court Judge erred in principle as well as in his application of the reasonable expectation of profit test, as it is now understood. He did not consider all of the factors he should have considered, nor did he assess the context fully. The evidence clearly showed that the tax- payers engaged themselves in a business enterprise and their expectations of profit were not unreasonable in the circumstances. A small rental business was launched without the aid of sophisticated market analysis at a time when the rental market looked promising. Soon after, as a result of unforeseen circumstances, it became precarious. No personal benefit accrued to the taxpayers by the rental arrangements. The property was not a vacation site. The house was not used to give free or subsidized housing to relatives or friends. They made an honest error in judgment and lost money instead of earning it. It is not for the Department (or the Court) to penalize them for this, using the reasonable expectation of the profit test, without giving the enterprise a reasonable length of time to prove itself capable of yielding profits.

In summary, the decision of this Court in Tonn does not purport to alter the law as stated in Moldowan. Tonn simply affirms the common-sense understanding that it is not the place of the courts to second-guess the business acumen of a taxpayer whose commercial venture turns out to be less profitable than anticipated.

In examining the activities of the appellants in the within appeals, one wonders why someone would store their own vehicle on the driveway outside a heated garage - filled with various amusement games and devices

- during a Regina winter and work 40 to 60 hours a week in a business that has produced only losses to date. Whether or not the amount of profit expected is reasonable or otherwise - depending on one’s point of view - however, is not to be confused with a reasonable expectation of profit. There was a small profit in 1996 and the 1997 year may yield a small profit or loss. The appellants, through K2V2, had gross revenues of $27,063.50 in 1993 and $29,353.95 in 1994, against expenses of $40,634.92 and $43,130.91, respectively. The resulting losses were $6,786.00 for each appellant in 1993 and $6,888.00 in 1994. They have been operating since 1987 and only showed a profit in 1996. In the course of operating the business they decided to embark on a major expansion of revenue which did not turn out to produce the desired results. Later, they struggled to stay current within the industry and kept expenses to a minimum. As well, they changed direction and placed less reliance on video games which are prone to downturns in a fickle marketplace and invested in coin-operated pool tables and similar machines which also have value in an after-market. The amount of service work has increased and other costs, including interest, are being reduced. The position of the appellants during 1993 and 1994 was such that no profit was produced during that time frame but for reasons directly attributable to past events in the life of the business. The numbers produced are such that it seems to be not worth the trouble considering the investment of money, time and effort by both appellants. However, if it can produce a modest, steady profit in the future to supplement retirement and other income, then the course of action, albeit difficult, chosen by the appellants, will yield the desired result.

In conclusion, having regard to all of the evidence and applying the jurisprudence to the facts in the within appeals, I find the appellants did have a reasonable expectation of profit during the taxation years under appeal. I also find the expenses claimed are reasonable, including the expenses pertaining to use of vehicles and business travel. The appeal of each appellant is allowed, with one set of costs, and the assessments of each appellant are referred back to the Minister for reconsideration and reassessment on the basis each appellant be permitted to deduct business losses, as claimed, for the 1993 and 1994 taxation years.

Appeal allowed.