Hartt v. R., [1997] 3 C.T.C. 2431, 97 D.T.C. 1407

Bowie T.C.J.:

1 These appeals are brought from reassessments of the Appellant's liability for income tax for the years 1988, 1989, 1990 and 1991. In each of those years the Appellant claimed to be entitled to take a business loss into account when computing his income. The business losses claimed by him were said to arise from expenses which he incurred in the promotion of an invention called the Andersen Round Saw (the invention, or ARS). The amounts expended by him, and claimed as losses, in the years under appeal are:

1988	$14,187.00
1989	$17,550.00
1990	$26,317.00
1991	$20,968.00

2 It is not in dispute that Mr. Hartt expended these amounts or that he did so in promoting the invention. What is in dispute is whether he did so for the purpose of gaining or producing income from a business of his own, or whether he did so in furtherance of the business of a company formed for the purpose of developing the invention, and of which he was a minority shareholder.

3 There is a subsidiary issue with respect to the years 1988 and 1989. It is the Appellant's position that these years were statute-barred at the time the Notices of Reassessment were issued to him. The Minister of National Revenue relies on subparagraph 152(4)(a)(i) of the Income Tax Act (the Act), alleging that the Appellant, through neglect or carelessness, made misrepresentations in filing his returns for those two years, and that she was therefore entitled to reassess beyond the usual three year limit.

4 The Appellant had a long and successful career as a federal public servant. At various times he held a number of positions of considerable responsibility in various departments of government, including the Department of Finance and the Treasury Board Secretariat. His last post before his retirement was as an Assistant Deputy Minister in the Department of Public Works and Government Services, where his mandate was to regularize the financial operations of that department. Upon retiring from the public service he returned to his native New Brunswick to settle in the village of Minto. It was his intention to participate in whatever promising business opportunities might come his way. His education and experience in the financial aspects of public administration suited him for this, and, in addition to a comfortable pension, he had a certain amount of capital available to invest. Prior to the events which gave rise to these appeals he had been involved in at least two other business ventures.

5 Mr. Andersen is a sawmill operator in New Denmark, in the northern part of New Brunswick. He has created a number of inventions over the years, but for various reasons he was never very successful at exploiting them. One of these, which had some prospect of being a commercial success, was the ARS. This saw was capable of sawing around a log to remove its bark, rather than simply sawing the log lengthwise in the conventional way. Its potential value lay in the fact that by removing the bark from the log before sawing it into lumber it could produce a substantially greater volume of sawn lumber from a saw log than the more conventional method. Mr. Andersen saw a great future for this invention, and he sought government funding to assist him in its development. This involved the usual difficulties encountered by small businessmen when they deal with the bureaucracy of government, something at which Mr. Andersen was not particularly adept. For this reason officials of the New Brunswick Department of Industry introduced him to Mr. Hartt, whom they knew to be a person well able to understand and deal with the requirements of government departments, and who they knew might be interested in taking part in the development of such an invention. By May 1988, approval had been obtained from the governments of Canada and New Brunswick to provide financial assistance in the development of the invention to the level where it would be ready for commercial production. The two governments were to provide $70,000.00 to build and test a prototype.

6 A hand-written letter dated November 5, 1988, from Mr. Andersen to the Appellant set out the terms upon which the two initially joined forces in this endeavour. Mr. Andersen guaranteed that Mr. Hartt would have, not less than a 5% share in the company or companies, to be established to develop the invention, and that he would hold the position of Executive Vice-President, with a salary and benefits commensurate with the duties involved. In return Mr. Hartt was to contribute at least 50% of his time to the project until October 31, 1990. No salary or other remuneration would be paid to him, however, until the ARS reached the stage of production and achieved a significant positive cash flow.

7 On November 25, 1988, the two corporate vehicles, Andermac Developments Ltd. (ADL) and Andermac Industries Ltd. (AIL) were incorporated. ADL was to own the rights to the invention, develop the prototype, and bring it to the stage of production. AIL would be the Canadian production company. Mr. Andersen was the President, and had a 95% ownership interest; Mr. Hartt was Executive Vice-President, with 5% ownership. The arrangement was that Mr. Andersen would contribute his invention, while Mr. Hartt would contribute half of his time for the next year, and the governments of Canada and New Brunswick would provide the necessary funding to develop a working prototype which could be brought to the stage of production. All parties were optimistic as to the future profits to be achieved from the invention.

8 Their optimism proved to be unwarranted. The building of the prototype was begun in Edmundston, New Brunswick. The initial version was not a success, due at least in part to design problems. It was then moved to the Hugh John Fleming Forestry centre in Fredericton to be upgraded, and subsequently to Minto, where further work was done on it by Minto Machine and Welding Co. Additional design work was done during this period by a company called Motion Design Ltd. At the same time a market study was conducted by a firm called Quest-Com Ltd., which reached the conclusion that there was indeed a market for the ARS if it could be successfully developed to the point of manufacture. Many problems were encountered, however, and in the end the project was abandoned without a viable prototype having been completed. The deathknell, it appears, was sounded sometime in 1992 when the provincial government ceased to provide financial support. By that time there had been at least one amendment to the original agreement of 1988. An agreement entered into among Mr. Andersen, AIL, ADL and Mr. Hartt in April 1990 recites that Mr. Andersen was the beneficial owner of 70% of the issued common shares of the two corporations, and that Mr. Hartt was the owner of the other 30%. It goes on to provide that they will be the two directors of the two corporations, and that Mr. Hartt will be Vice-President and Managing Director, with veto power over any significant changes in the corporate structure. Mr. Andersen and Mr. Hartt both covenanted to devote their full time and attention to the affairs of the corporation, for which they were to receive equal salaries and bonuses. So far as I can tell from the evidence no salary or bonus was ever paid to either of them.

9 There is a paucity of evidence as to the corporate affairs and the finances of these two companies. Other than the references in the agreements between Mr. Andersen and Mr. Hartt as to their relative shareholdings, there is no evidence as to shares being issued or paid for, nor of any meetings of shareholders or directors having taken place. The evidence at trial did include most, but not all, of the monthly statements for an account at the Royal Bank of Canada in Minto in the name of Andermac Development Ltd. These statements show very little activity in the bank account. It was opened with a deposit of $2,700.00 on December 9, 1988, and that was followed by a deposit of $13,000.00 on December 12, 1988, apparently the product of a government grant. There are subsequent debits of $13,000.00 on December 13, 1988 and $2,600.00 on December 19, 1988 leaving a balance of $100.00 at the end of that month. There is a further debit of $36.32 on January 11, 1989. There was a deposit of $600.00 on January 6, 1990 and $575.00 was debited the same day. On April 2, 1990 there is a deposit of $2,400.00, and a debit in the same amount. Other than the $7.00 monthly service charge these appear to be the only banking transactions of the company. On August 20, 1990 the Bank apparently wrote off an outstanding overdraft of $24.69, and closed out the account. Some of the funds deposited came from government grants. The rest came from the Appellant.

10 While all of this was going on, Mr. Hartt was making significant expenditures in furtherance of the project from his own personal bank account. The documents introduced into evidence by the Appellant at the opening of the trial include copies of four cancelled cheques payable to Quest-Com Ltd. These total slightly more than $11,000.00, and are drawn on Mr. Hartt's personal bank account. While these are the only cancelled cheques put into evidence, I understand both from the pleadings and from the conduct of the trial that it is not disputed that the amounts claimed by the Appellant were in fact expended by him from his personal funds in furtherance of the development of the ARS.

11 There can be no doubt that these amounts were spent on the business of ADL, and not that of the Appellant. I believe the evidence of the Appellant and Mr. Andersen to the effect that the two companies were created only because the receipt of government grants was dependent upon the business being incorporated, and not simply operated as a proprietorship or a partnership. Mr. Andersen testified that he conveyed the patent which he had obtained on the invention to ADL. Again, this was to satisfy the requirements of the two governments which were providing grants. The exhibits at trial include a number of letters between Mr. Hartt and various officials of the governments of Canada and New Brunswick. Letters to Mr. Hartt are addressed to Andermac Development Ltd., to the attention of Mr. Douglas J. Hartt, Executive Vice-President. Letters written by Mr. Hartt are signed by him as Vice-President, Andermac Development Ltd. The business of developing the invention was certainly that of the corporation, and not of Mr. Hartt. Indeed, I did not understand his counsel to contend otherwise. Instead, he put the case on the basis that, to the extent that Mr. Hartt paid the bills of ADL from his own bank account, it was the acquisition by him of an interest in the company, and that he acquired that interest not as an investment, but as an adventure in the nature of trade. In support of that argument he relied upon the judgment of the Supreme Court of Canada in Minister of National Revenue v. Freud,[FN1: <p>(1968), [1969] S.C.R. 75 (S.C.C.).</p>] and on the judgment of this Court in Skerrett v. Minister of National Revenue[FN2: <p>(1991), 91 D.T.C. 1330 (T.C.C.).</p>] .

12 In Freud, the Appellant formed a company for the purpose of developing the prototype of a sports car. It was the intention of the Appellant and his associates to create a working prototype, not to manufacture the car themselves, but with a view to perfecting the invention and then selling it to another company which would manufacture it. As in this case, the Appellant laid out his own funds, both in the form of advances to the corporation and in payment of various debts of the corporation, with no indication as to whether these amounts were treated as loans to the corporation, or as payment for shares issued, or to be issued at a future time. At issue was the question whether the Appellant could deduct from his other income an amount of some $13,840.00 expended by him in a final attempt to sell the sports car concept to what, apparently, was the last potential buyer for it. The attempt was unsuccessful, and shortly thereafter the project was abandoned and the Appellant's investment, including this $13,840.00, was lost. The Supreme Court of Canada held this amount to be a business loss of the Appellant on the basis that it, like his earlier contributions to the company, was not an investment intended to produce income through the manufacture and sale of automobiles, but an adventure in the nature of trade, with the profit to come from a sale of the company, not from the sale of sports cars.

13 Although there are superficial similarities, this case differs from Freud in a material way. It was established by the evidence in Freud that the intention of the developers of the sports car in that case was from the beginning that they would develop a workable invention which they would sell to others to manufacture. They had no intention of maintaining their involvement beyond the point of development of a working prototype. I do not find that the evidence supports a similar conclusion with respect to the Appellant in this case. Indeed, the only evidence tending towards that result came during the cross-examination of the Appellant, when he indicated that as he was getting on in years it was his hope that he would realize the fruits of his outlay of time and money by selling his rights to his share of the income that would flow from the successful development of the invention. This evidence is, of course, highly self-serving, and it is not corroborated in any way. It is also at odds with what the documents reveal, which I find to be more reliable.

14 Nor does the Skerrett case assist the Appellant. There the taxpayer acquired an interest in certain real estate in the Bahamas through what was called a Unit of Participation. The ownership interest was structured in a peculiar way for reasons having to do with corporate financing and the incidence of taxation. The taxpayer suffered a loss upon disposing of his interest, which Sobier J. found to be a business loss. His reasons for doing so are to be found in the following passage from his Reasons for Judgment[FN3: <p><em>supra</em>, at 1334</p>] :

The venture was a speculation, no long term income was ever anticipated. The only business was to sell the lots and share in the income. When that was completed, the enterprise would be at an end. Accordingly, I find that the Appellant was engaged in an adventure in the nature of trade.

15 In contrast, Mr. Hartt and Mr. Andersen incorporated two companies, one of them to develop the invention, and one of them to exploit it through manufacture and sale of the saws. This is confirmed by the agreement of April 12, 1990, to which Mr. Andersen, Mr. Hartt and the two companies are signatories. It is reinforced by the terms of their original agreement embodied in Mr. Andersen's letter of November 5, 1988 to Mr. Hartt which provided, among other things, that “payment of salary or other remuneration [to the Appellant] will only commence once production starts and significant cash flow is achieved”. In giving the reasons for judgment of the Court in Freud, Pigeon J. said[FN4: <p>Page 83.</p>] :

It is, of course, obvious that a loan made by a person who is not in the business of lending money is ordinarily to be considered as an investment. It is only under quite exceptional or unusual circumstances that such an operation should be considered as a speculation. However, the circumstances of the present case are quite unusual and exceptional. It is an undeniable fact that, at the outset, the operation embarked upon was an adventure in the nature of trade. It is equally clear that the character of the venture itself remained the same until it ended up in a total loss. Under those circumstances, the outlay made by respondent in the last year, when the speculative nature of the undertaking was even more marked than at the outset due to financial difficulties, cannot be considered as an investment. Whether it is considered as a payment in anticipation of shares to be issued or as an advance to be refunded if the venture was successful, it is clear that the monies were not invested to derive an income therefrom but in the hope of making a profit on the whole transaction.

16 The unusual and exceptional circumstances of the Freud case are not duplicated here. The evidence is equivocal as to whether the various payments made by the Appellant were intended to be loans, or to assume some other character. It seems unlikely that they were intended to increase the Appellant's equity interest, which was apparently fixed at 30% at the time of the agreement of April 12, 1990 and which, according to the evidence, Mr. Andersen was unwilling to see increased to 40% as proposed by the Appellant in September 1990. I need not resolve this question however, as I am satisfied that these advances, whether equity or loan, were in the nature of an investment by the Appellant in AIL and were not part of an adventure in the nature of trade. It follows that the Appellant's contention that he is entitled to deduct these amounts from his other income as business losses must fail.

17 I turn now to the question whether the 1988 and 1989 years are statute-barred. The reassessments for these years are dated March 21, 1994. It is common ground that this is outside the three year normal period for reassessment. Subparagraph 152(4)(a)(i), upon which the Minister relies, reads:

152(4) Subject to subsection (5), the Minister may at any time assess tax for a taxation year, interest or penalties, if any, payable under this Part by a taxpayer or notify in writing any person by whom a return of income for a taxation year has been filed that no tax is payable for the year, and and may

• (a) at any time, if the taxpayer or person filing the return

• (i) has made any misrepresentation that is attributable to neglect, carelessness or wilful default or has committed any fraud in filing the return or in supplying any information under this Act, or

18 The evidence of the Appellant on cross-examination was that his returns for 1988 and 1989 were prepared by a firm called Agricultural Tax Services Ltd. He gave the firm a large number of disorganized receipts, and after some time they told him that they could not understand them, and that he would have to organize them himself. This he apparently did, and as a result, income tax returns for 1988 and 1989 were prepared for his signature. He said in his evidence that he signed these without first examining them to verify their correctness. It is not disputed that there were some very substantial claims for expenses made in the returns for each of these years which were quite properly disallowed by the Minister in making the reassessments in question. These are claims quite separate from those relating to the development of the ARS, and pertain to another quite different business in which the Appellant was involved. These improperly claimed expenses for 1988 and 1989 were $7,559.00 and $13,683.00, respectively.

19 There can be no doubt that the Appellant was at least careless in claiming these deductions on his 1988 and 1989 returns. He is a person of considerable financial sophistication. He has held senior positions in the federal government, in which his duties related to financial management. I find it quite astonishing that such a person would file income tax returns without carefully scrutinizing them first. The need for care is all the greater in circumstances where the Appellant had been told by his tax preparers that they were unable to reconcile the documents that he gave them. I conclude that the Appellant understood very well his obligation to take care to file accurate returns, and that he simply was willfully blind to it. Certainly a person of his background ought to have understood and complied with this obligation. I therefore find that the requirements of subparagraph 152(4)(a)(i) are met, and that the Minister was entitled to reassess the Appellant for the 1988 and 1989 taxation years.

20 The appeals are dismissed with costs.