McNally v. R., [1998] 2 C.T.C. 3104

Rowe D.J.T.C.:

1 The appellant appeals from an assessment of income tax for his 1993 and 1994 taxation years. The Minister of National Revenue (the “Minister”) disallowed business losses in those years in the sums of $34,003 and $27,983, respectively, claimed by the appellant as having been incurred as a consequence of operating a business under the name, “McNally's German Wirehair Pointers”.

2 The appellant testified he lives at Calahoo, Alberta and is employed, full time, as an engineer with Canadian National Railways (CN). He stated he was living in Morinville, Alberta, in 1989, when he began purchasing German Wirehair Pointers. During that year and following, in 1990, he purchased a total of three dogs, two females and one male. At that time, he was living in a house in a subdivision and he began receiving complaints from his neighbours concerning the dogs. In 1991, he found an 80-acre parcel near Calahoo, in the County of Sturgeon, within a one-half hour drive from Edmonton, where the land-use regulations permitted the discharge of firearms, which is required in the course of training his dogs. The parcel was raw land and he took up residence there by living on the land in a truck and camper. He had telephone service brought to the property and he cleared land in order to built a 36-foot by 24-foot shop with runs and kennels for the dogs. He also drilled a well for a water supply. During this period, he was working full time and was absent from the property for 12 hours at a time. The appellant explained he had been born in Northern Ontario and had grown up with hunting dogs. During his childhood and teenage years, he had raised beagles and Springer spaniels. In 1979, he moved to Alberta. Later, he began working with a man who had worked with dogs all his life and who, in the course of discussions with the appellant, recommended a breed called German Wirehair Pointer, a water dog, weighing 55-60 pounds, with hard, flat dense hair. The appellant stated he undertook some research on this breed and purchased, for the sum of $400, a male named Major from a breeder at Medicine Hat, Alberta. Major, in 1988, became a Show Champion at a particular competition. There are individuals interested in hunting who are willing to pay the sum of $600 for a pup and the appellant stated he now has six female and five male dogs and is able to sell a year-old female for $1,000 and a two-year old, trained, dog for as much as $2,500. He is also in the process of constructing a log home on the property and, in order to do so, purchased a crane and a tractor. McNally referred to a Statement of Income and Expenses - Exhibit A-1 - pertaining to his 1993 taxation year. Filed as Exhibit A-2, was a Statement of Income and Expenses for his 1994 taxation year and, as Exhibit A-3, a Schedule indicating gross revenue, expenses and losses for the years 1989-1994, inclusive, arising from the operation of his dog business. He also filed, as Exhibits A-4 and A-5, a series of photographs depicting the property at Calahoo during different seasons, some dogs, some horses, and pens for the pheasants. The appellant explained he constructed a road in 1993 in order to cross a stream and coulee because his dogs require water for training and he must raise ducks on the pond which are also used in the development of the dogs' hunting and retrieving skills. All competitions involving the German Wirehair Pointers are carried out by dog owners or handlers who are mounted on horses, running the dogs, and the competition judges are also on horseback. The dogs compete in a hilly area, over a time period of 30 minutes, in which they are to locate pheasants, quail and other game birds which have been planted on the property by the competition organizers and are then flushed by someone firing a starter's pistol. In order to obtain maximum points from the judges, the dogs must work with a minimum of direction from the mounted person. The appellant stated it was necessary to purchase horses for the purposes of training his dogs and discovered a breed of horse called Tennessee Walkers which walk very smoothly and make it much more comfortable for the rider during the course of an arduous week-end competition. He now has one thoroughbred, aged six, one three-year old stud and three mares. He explained it was cheaper to buy a crane - at $5,000 - in order to assist with the construction of the log house on the property than it was to rent one at a high hourly rate. In any event, in 1997, he sold the crane for the sum of $6,000 and felt it had served him well in the building process. In 1995 and 1996, the appellant stated he did not claim any business losses and was trying to finish construction of the log house - 2,400 square feet - and could not obtain sufficient loans from any financial institution to allow him to develop the property more quickly. He stated he used a portable sawmill in order to reduce the costs of construction. He had also decided to purchase pheasants for use in training the dogs but the incubator broke and the eggs spoiled. The appellant stated that his inventory of animals on the property at present is as follows: six female dogs, four of breeding age and two pups, and four males, one of whom, JR, is a Field Champion, and another is JR's offspring, Cocoa, and five horses, including three mares and one colt, two pheasants and 25 hens. The appellant stated that his dogs have done well, over the years, in various competitions. In 1995, he won second place in a competition for the top pointing dog. In 1991, Major finished first out of 32 dogs and another dog finished second in a trial held in Seattle. The appellant stated he turned down an offer of $8,000 for Major because the dog was needed to provide quality pups. There are problems associated with breeding dogs and, in 1993, nine pups died at birth. However, there is usually no difference in quality between surviving pups in a litter. Because his dogs are of excellent quality, the appellant stated he now needs to locate some wealthy people to purchase the animals. The German Wirehair Pointers make good pets, are quite versatile and have a lot of stamina. A six-week old pup can be sold for as much as $800 but he attempts to screen buyers so as to have some assurance the animals will be properly exercised. He stated the ideal inventory is five females and five males because a larger number than that requires additional time and the available time for a training period per dog becomes reduced. In 1993, he did some dog training for others but found it not to be worthwhile and he abandoned that line of endeavour. The appellant stated he has all the proper training facilities and the normal fee is $450 per month per dog for a limited training session of three months. However, he indicated the dogs have to be worked all year-round because, “all they know is how to find birds”. He regards his dog operation as having all the required attributes in order for it to be successful including 80 acres of land, fields for hay, land for growing grain for the birds he raises to use during training and room for the horses.

3 In cross-examination, the appellant stated that, for the most part, entry fees, hotels and travel to competitions would remain the same. The advertising would increase in some years and the license and insurance costs would be nearly the same in each year. The dogs are not insured against loss. He would continue to incur veterinary bills, even though he provides a lot of this care on his own, but his interest costs have been reduced and the maintenance and repair costs were high during 1993 and 1994 because there was a need to purchase a lot of small tools. He no longer has any need to pay wages to assist him as his friend and her son live on the property. He also stated he has a flock of 100 pigeons which he used for training the dogs. The appellant agreed his expenses during the years from 1991 to 1994, inclusive, ranged from $34,022 to $42,535 while his income was $7,500 in 1991, $8,400 in 1992, $7,785 in 1993 and $14,552 in 1994. He conceded that, in order to generate sufficient income to meet even the current expectation of reduced expenses, he would have to sell a minimum of 35 pups per year at a price of $600. He indicated that many sales occurred as a result of referrals from persons who were familiar with his dogs. In response to a question about his commitment to his dogs, the appellant replied, “I will be involved with hunting dogs until the day I die”.

4 Counsel for the respondent submitted there was no reasonable expectation of profit during the years under appeal as the evidence showed the appellant had accumulated losses in excess of $148,000 since 1989 and did not have the capacity to generate a profit during the years under appeal or thereafter.

5 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. (1977), [1978] 1 S.C.R. 480 (S.C.C.). Linden, J.A., writing for the Court, undertook the analysis and, reproduced below, is a review of the case law commencing at page 6009 of the reasons of His Lordship:

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 into 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.

One such hobby case is McKay v. Minister of National Revenue where Brulé T.C.C.J., in deciding that an underwater diving instruction and photography operation did not comprise a business, stated:

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.

It is not that the impugned activities in these cases are in themselves any more or less prone to being run like a business. Rather, it is the simple fact of how they are run which is decisive: though the taxpayer might well desire to profit from the activity, the profit motivation is not the main reason for the activity. Rather, the element of personal enjoyment is the dominant, motivating force.

In another hobby case, Escudero v. Minister of National Revenue, the applicant deducted losses arising from a dog-breeding operation. Though the operation was run ostensibly as a business, the taxpayer had an obvious personal interest in dogs, which was evidenced, among other things, by the fact that the appellant had purchased a mobile home for attending dog shows. In deciding that the deductions were correctly disallowed, Chairperson Cardin stated:

Although the appellant's breeding kennel may be operated in a business-like manner, it lacks, in my opinion, the one essential ingredient to make it a business and that is a reasonable expectation of profit. On the basis of the evidence and particularly the financial statements for the years 1975 to 1980 inclusive, I do not believe the appellant can, in the foreseeable future, reasonably expect to realize the profit from the operation of his breeding kennel. For whatever reason the appellant may have engaged in the breeding of pure stock St. Bernard dogs, it was not, in my opinion, for the purpose of realizing a profit from the breeding operations.

A further case illustrating the personal benefit element in Huot v. Minister of National Revenue In this case, the taxpayer acquired certain properties from his parents and in turn rented one of them to his parents for a rental value far below the market rate. The applicant then attempted to deduct losses arising from this arrangement. The Tax Court Judge properly found that the applicant did not entertain a reasonable expectation of profit and dismissed the appeal.

Lastly, in Maloney v. Minister of National Revenue, a taxpayer rented a house she had purchased from her mother back to her for a low rent and attempted to deduct the losses incurred. In deciding that a motive of personal benefit predominated in these circumstances, the Tax Court Judge stated:

I do not doubt in any way the good faith of the Appellant. She presented her own appeal with sincerity and conviction. I find, however, that the plan for the mother to be self-supporting and thereby pay a reasonable rent which would permit the Appellant to derive income from the property is a plan that was not well thought out. The subjective, good faith, commercial hopes and dreams of an individual taxpayer do not confer upon his or her enterprise a reasonable expectation of profit if that enterprise does not meet the objective criteria of a prudent business in similar circumstances.

The other group of cases consists of situations where the taxpayer's motive for the activity lacks any element of personal benefit, and where the activity cannot be classified as a hobby. The activity, in these cases, seems to be operated in a commercial fashion and not as a veiled form of personal recreation. Usually these deductions are not challenged by the Department, and, therefore, they do not get appealed and are not reported very often in the law reports. The Courts still have a role, however, in deciding whether there exist less apparent factors which might suggest a different conclusion in cases such as these. The Courts are less likely to disallow these expenses, but they do so in appropriate circumstances.

Thus, in Baker v. Minister of National Revenue, Couture C.J.T.C. found that the taxpayer conducted himself in a business-like manner and that it would not be appropriate to disallow the deductions he claimed:

In the present appeal, it appears to me that the Appellant conducted himself like a normal average investor, an investor who was not sophisticated because of lack of professional training, but who nonetheless had a working knowledge of the basic rules of the investment process. He knew the area where the property was located. He had received assurances from the real estate agent that there would not be any problem renting the property throughout the year and furthermore the agent had indicated the rent that could be obtained.... The fact that the rental projections did not materialize, which was the main and only cause of the failure of the venture certainly cannot be imputed to the Appellant. It was simply part of the risk related to the venture.

In a contrasting case, the taxpayer attempted to deduct rental losses on a property. While recognizing that it is inappropriate for the Minister or the Court to substitute its business judgment for that of taxpayer, Bowman, T.C.C.J. found that the operation did not meet the Moldowan criteria:

Nonetheless, there must be sufficient of the indicia of commerciality to justify the conclusion that there is a real commercial enterprise being conducted. I do not find that the arrangements made by the appellant contain those indicia. The 100% financing, the payment of a 25% commission to Port Charlotte Homebuilders and the substantial expenses and consequent loss in comparison to the gross revenues and the overall cost of the property are among the factors that I find inconsistent with a genuine commercial operation.

This conclusion does not of course justify the automatic disallowance of losses in the early years of a genuine viable rental operation. There should be a reasonable period in which to permit the enterprise to become self-supporting. In the years under appeal, I do not think it had reached the stage where it can be called either a business or a viable rental operation.

Other cases utilize the Moldowan case in what appears to be regular commercial type situations exist. The facts, of course, are always of importance in sorting out which cases will be placed on the other side of the line. Hence, where a commercial enterprise is operated at a loss in order to generate tax refunds or other such tax consequences, the Court will likely find that the enterprise is not a business under the Moldowan test. In other situations, the Court may decide that, though the taxpayer genuinely intended the pursuit of profit through a purely commercial activity, the intention was unrealistic, the expectation of profit unreasonable, and hence, the activity was not a business. This was the situation before this Court in Landry v. Q. In deciding that a lawyer's expectation to earn a profit from a rejuvenated legal practice, recommenced in his seventies, was not objectively reasonable, Décary, J. stated:

It is possible for someone, with the best will in the world, to practise an activity that takes all his or her time and that activity may still not be a business for the purposes of the Income Tax Act.... There comes a time in the life of any business operating at a deficit when the Minister must be able to determine objectively, after giving someone a head start for a number of years, as the case may be, that a reasonable expectation of profit has turned into an impossible dream.

I might note for the record that the factual circumstances in Landry were not entirely free from suspicion. One significant source for the losses claimed in the case was part of the cost of the personal residence of the taxpayer from which the practice was run at least part of the time.

In another case, Engler v. Q. a taxpayer attempted to deduct losses from a small business he formed to buy and sell various gift items such as brassware, watches, rings and household gadgets. The profits intended from this business were to supplement the taxpayer's employment income. Though no personal element was apparent in how the taxpayer ran the business, and though the type of business suggested a bona fide commercial operation, the losses arising from it were held to be non-deductible because the venture lacked a reasonable expectation of profit. Even though the operation could not otherwise be impugned, the rather large losses claimed were too suspicious to be overlooked, thus suggesting that a non-commercial intention lay at their source. In deciding the matter, Joyal, J. stated:

On the evidence, it might be said that the plaintiff originally brought the whole controversy upon himself by claiming expenses which could not by any stretch of the imagination be justified. In the face of this obvious disproportion between the resulting losses and the volume of business generated, or the capital committed, or the time and energy devoted to it, it was an easy slide from a determination of the unreasonableness of the expenses to an assumption that the venture, in any event, did not have a reasonable expectation of profit.

I also find the following words from earlier in the judgment instructive:

It is only when the taxpayer has other sources of income against which any such losses are claimed that Revenue Canada's antennae start sending out signals which might become a source of concern to the taxpayer. Depending on the circumstances in each case, Revenue Canada will assume that the taxpayer is engaged in a business which objectively has no reasonable expectation of profit. The inference will be drawn that the taxpayer is merely engaged in a sport, hobby or some other self-satisfying endeavour, and if his losses are charged to his other sources of income, he is effectively reducing his tax exposure.

The difficulty the taxpayer could not overcome was the inference, derived from the unreasonable nature of the expenses, that the business was in fact not operated for business reasons.

When the cases are categorized into two groups as above, one cannot help observing that the hobby and personal benefit cases are rarely decided in the taxpayer's favour. In contrast, where the activity is purely commercial, they rarely are challenged. If they are the Courts have been reluctant to second-guess the taxpayers, with the benefit of the doubt being given to them. I also note that in terms of sheer numbers, the hobby/personal-benefit cases vastly outnumber those of the commercial activity and variety, which are quite rare, indicating that taxpayers are challenged less often in such situations.

The primary use of Moldowan as an objective test, therefore, is the prevention of inappropriate reductions in tax; it is not intended as a vehicle for the wholesale judicial second-guessing of business judgments. A note of caution must be sounded for instances where the test is applied to commercial operations. Errors in business judgment, unless the Act stipulates otherwise, do not prohibit one from claiming deductions for losses arising from those errors. This point was stated strongly by Sheldon Silver:

It is submitted that it should not be the role of Revenue Canada to determine what businesses taxpayers should attempt to pursue. In fact, governments in Canada have often stated that new businesses and risk-taking should be encouraged and have, from time to time, enacted legislation to encourage such activity. Canadian chartered banks have recently been seriously criticised by the press and government officials for not providing adequate lending facilities to small and new businesses. Clearly, Revenue Canada's attempt to penalize taxpayers who are unsuccessful after taking these risks is inconsistent with the government's promotion of private entrepreneurs.

This criticism was echoed by Bowman, T.C.C.J. in Bélec v. Q. where he stated:

It must be noted that these losses were incurred solely in a business context. There was no personal element, either in his purchase nor in his use of the building. The appellant is an experienced businessman. He took his decision in good faith on his best judgment and on the facts available to him at the time. It is not up to the Minister (or this Court) to substitute his business acumen for that of the taxpayer, with the benefit of hindsight. The question to be asked is not, “Knowing what I know now, would I have embarked upon this enterprise?” The answer is no doubt “No”, because the question only comes up when there are losses.

And finally, the same caution was reiterated in Nichol v. Q.:

[Mr. Nichol] made what might, in retrospect, be seen as an error in judgment but it was a matter of business judgment and it was not one so patently unreasonable as to entitle this Court or the Minister of National Revenue to substitute its or his judgment for it, or penalize him for having made a judgment call that, with the benefit of 20-20 hindsight, that Monday morning quarterbacks always have, I or the Minister of National Revenue might not make today. We were, after all, not there in 1986.

Though I do not support the use in the Nichol case of the word “patently”, 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.

6 It is apparent from the evidence the appellant has long held an interest in hunting dogs and indicated this devotion would continue as long as he lived. The difficulty in these types of cases is that, in order to be successful, one has to be extremely dedicated to the particular type of animal and to be willing to do what is required including adopting the appropriate lifestyle. The nature of the examination required is an objective one, involving the head - as opposed to - the heart. The appellant was attempting to do too many things at once. He embarked on a course of action which appeared to involve his own concept of vertical integration so that he could become nearly self-sufficient in order to control quality and reduce costs. He purchased 80 acres of land so that he would have the space required to train the dogs, including the land-base needed to raise the horses - Tennessee Walkers - and to provide adequate water in the forms of streams and ponds in order to raise ducks. He also raised pheasant and pigeon to use in the training of the dogs. Then, he was building a house which he indicated was necessary in order to accommodate visitors to his business and he purchased a crane and a tractor to assist in the construction. There was a great deal of expense in constructing the runs and the kennels. He entered his dogs in competitions and had a high degree of success which he believed would lead him to the point where his pups would be in demand by people who would pay excellent prices in order to own such a quality dog. The development of this elaborate superstructure was undertaken to create an inventory of 10 dogs, only four of which were breeding females, in 1997. These four dogs and the male studs the appellant owned had to produce enough saleable offspring to support the costs of running the 80 acres, the buildings, paying interest charges, veterinary bills, fuel, automobile expenses, capital cost allowance, feed and care for five horses, and an assortment of game birds. The competitions themselves produced no money by way of prizes so the appellant's opportunity to realize a profit was from selling sufficient pups in order to generate adequate income even though, in 1994, the appellant had income of $7,400 from the sale of two horses and another $1,500 from selling pheasants. The appellant continued to work full time at the CN. During the years in issue, he would have had to sell nearly 70 dogs per year in order to break even. This is difficult to do even though the appellant had stated he believed it should not be that difficult to get 14 pups - in two litters per year - from each female, and, if he had six breeding at once, could end up with 84 pups. However, the most pups he ever sold was 13, in 1994, and, as a result of the assessment by the Minister disallowing his losses, he stopped selling dogs in 1995 and 1996 and turned his attention to finishing the house. Apart from the personal element involved in the within appeal, the ability of the enterprise to function under circumstances where it might have a reasonable expectation of profit was hampered by the lack of maturity of the activity, as structured, to be anything other than a pursuit - in the early developmental stages - of a country-gentleman dog-fancier looking to create an idyllic hunting dog resort in the country near a metropolitan area. There is no doubt the appellant has a lovely place which might be well suited to a bed and breakfast or a cross-country ski hide-a-way but it did not have the capacity to pump out enough revenue in the years under appeal, and thereafter, to pass the business test. Although the appellant stated he was searching for a profit - as opposed to merely satisfying a personal hobby - and had gone through the earlier years from 1989 to 1992 during which he relocated and expended time, money and energy to improving the property and making it suitable for his needs - his projections were not reasonable. Moreover, his decision to stop the activity in 1995, and thereafter, because losses had been denied him by the Minister's reassessment does not leave one in the position of having evidence of what might have been had he stayed the course. It was not necessary to get into the nitty-gritty of the appellant's view of what is a properly deductible business expense but the appellant had claimed certain expenses which - at best - would be on account of capital, such as road construction, and I fail to see how any costs associated with building a private 2,400 square-foot residence can be apportioned against the purported business - the raising and sale of dogs.

7 The Minister's assessment is correct and the appeal is hereby dismissed.