Date: 20000120
Docket: 97-3514-IT-G
BETWEEN:
HOWARD ROWE,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for Judgment
(Delivered orally from the bench on May 5, 1999 at Edmonton, Alberta)
Mogan J.T.C.C.
[1] This is an appeal in respect of the taxation years 1993, 1994 and 1995. In each of those years, the Appellant reported a loss from a commercial activity which he claimed was a business. He deducted the loss when computing his income. In the reassessments which are under appeal, the Minister of National Revenue took the position that the commercial activity was not a business because there was no reasonable expectation of profit. Accordingly, the losses were disallowed as deductions. Therefore, the primary issue is whether there was a reasonable expectation of profit in respect of the Appellant's commercial activity. There is also a secondary issue. If there was a reasonable expectation of profit, there should be determination as to the quantum of any profit or loss and whether it should be shared on a 50-50 basis with the Appellant’s wife.
[2]The Appellant and his wife Merle testified. Three or four persons associated with the Appellant also testified. On behalf of the Respondent, the initial auditor and the appeals officer testified. And so there was a wealth of oral testimony in this appeal. Also there were several documents put before the Court as exhibits.
[3]The Appellant has worked for an Edmonton newspaper since 1978. Sometime in the 1980s, he and his wife decided to supplement their income to provide for their security in their retirement years. They looked for some endeavour which showed at least the opportunity to earn significant profits in a relatively short period of time. The Appellant and his wife were married in 1964. By the mid-1980s, they had been married more than 20 years and were hoping to obtain some additional security for retirement.
[4]The Appellant has secure employment with the Edmonton newspaper but his wife had been eased out of her job around 1982 or 1983. She decided that although she was a highly qualified medical laboratory technician, there was more opportunity in the sales area. She would therefore pursue activities in sales with a view to enhancing her income. She had tried the travel agency type of work and had built up a clientele but was not satisfied with that and decided to go to a more direct type of sales.
[5]Her evidence and her involvement is important because she was a force in the endeavour and she was referred to by the Appellant's other witnesses. The other witnesses called on behalf of the Appellant were Ms. Goebel, Ms. Savoury, Ms. Fath and Mr. Jacques. Almost all of them described having connections with the Appellant’s wife with respect to the commercial activity operated by them. Therefore, the involvement of the Appellant’s wife was significant and, based on the way the Appellant testified, they were working together as a team.
[6]Whatever the Appellant's activities were before 1991, it is clear from the uncontradicted evidence of the Appellant and his wife that what they started in 1991 was a type of multi-level marketing which was dependent upon finding a saleable product; and then recruiting people to sell the product with an overriding commission coming to the recruiter. What attracted the Appellant was an organization called National Safety Associates and the product was a water filter. He thought that the water filter would be a good product to provide pure drinking water consistent with an awareness of environmental issues and also a greater awareness of health and safety standards. The Appellant and his wife bought a significant amount of product around 1991; recruited people to sell it and sold it over a period of time.
[7]The enterprise was hurt by a particular broadcast on the CBC in which an investigative reporter did a critical commentary on the water filter business. The broadcast made it more difficult to sell the water filter product. I believe the Appellant when he said the broadcast really hurt their sales. However, they stayed in the area of multi-level marketing and tried products called Third Dimension, Alberta Shopping Network, JewelWay, and WorldNet. Alberta Shopping Network was an attempt to sell pre-paid coupons to purchase goods. JewelWay was selling jewelry; and WorldNet was a type of long distance card where, by pre-paying a certain amount, a person would be able to make a number of long distance calls at a very reduced rate.
[8]Although there were references to these different enterprises, they were all merged together and there was not a separate profit and loss statement for each enterprise. They were all consolidated in the financial statements attached to the income tax returns so that they were merged as one ongoing multi-level marketing enterprise operated by the Appellant and apparently his wife. It was quite unlike someone who was operating both a flower shop and a hardware store and kept separate financial statements because the businesses were so different. One person might be the proprietor of both the hardware store and the flower shop and yet keep separate books of account. That was not the case with the Appellant concerning his different enterprises.
[9]The enterprise seemed to be multi-level marketing and, although the product might change depending upon its saleability, the revenues and expenses were merged in the Statement of Business Income attached to the Appellant’s income tax returns. For whatever reason, each one of these activities ran into difficulties. As I have mentioned, the water filter business was hurt by a damaging and perhaps unjustified commentary on the CBC. One of the other enterprises, I think the Alberta Shopping Network, was ordered to be closed down by a branch of the provincial government. The Appellant became disenchanted with the products in the JewelWay activity because the Appellant’s wife purchased a gold watch which lost its golden sheen within four months and turned a dark colour. Also, there was some problem with another product. The person in the United States selling it phoned the Canadian operation and said that he was no longer going to do business in Canada. He shut down the Canadian operation at a time when the Appellant had high hopes.
[10]In any event, for each year the Appellant reported a loss. For 1991 and 1992 the loss was shared on a 50-50 basis with the Appellant’s wife. She reported half the loss in 1991 and 1992. I will now consider the losses in the years under appeal (1993, 1994, 1995) and the question which comes up is whether, having regard to the enterprise itself and all the surrounding circumstances, there was a reasonable expectation of profit. There is a wealth of law on this question and many cases have been decided. Before turning to the law, I would like to put in focus the relative amounts because, in my view, they have a significant influence on the case.
[11]Exhibits R-1 to R-5 are the extracts from the Appellant’s income tax returns for the years 1991 through to 1995. The extract in each case is the Statement of Business or Professional Income which is like a profit and loss statement attached to the Appellant’s return. I will summarize these Exhibits as follows:
|
Year |
Gross Sales |
Net Sales |
Expenses |
Loss/Profit* |
|
1991 |
$2,788 |
($288) |
$5,114 |
($5,402) |
|
1992 |
6,406 |
(3,558) |
8,347 |
(11,905) |
|
1993 |
1,401 |
(98) |
17,476 |
(17,574) |
|
1994 |
1,019 |
1,020 |
5,404 |
(4,384) |
|
1995 |
360 |
360 |
9,425 |
(9,065) |
* Before automobile expenses
In 1991 and 1992, the losses were allocated between the Appellant and his wife. Because I have only the Appellant's return before me, in 1991 $2,701 was allocated to him. In addition to that loss, he claimed automobile expenses of $1,686, which produced an aggregate net loss of $4,387. For 1992, the net loss allocated to the Appellant was $5,952. Also, he claimed his share of automobile expenses of $1,566, producing a net loss of $7,518. Therefore, in the two years before the years under appeal, the Appellant has claimed losses of $4,387 and $7,518, respectively.
[12]With respect to the three years which are under appeal, there was no allocation between the Appellant and his wife. The losses were reported 100% by the Appellant. In 1993, there was a reported loss of $17,574; and on top of that the Appellant added automobile expenses of $10,318, which created a total loss of $27,892. In 1994, the reported loss was $4,384; and then automobile expenses of $7,464, created a net loss of $11,848. And lastly, in 1995, the loss was $9,065 plus automobile expenses of $5,710, creating an aggregate loss of $14,775. In the three years under appeal, the net losses after automobile expenses were as follows:
1993 - $27,892
1994 - 11,848
1995 - 14,775
[13]The Revenue Canada auditor was asked why he disallowed the losses in the years under appeal after allowing the losses for 1991 and 1992. He stated that he regarded 1991 and 1992 as start-up years for this business, and the losses were a reasonable allowance, but he said there were declining revenues in the years under appeal. He referred to the revenue in 1993 as insignificant and dropping. I think that is a fair comment because in the years under appeal the gross revenue was $1,401, down to $1,019, down to $360.
[14] In my view, these appeals cannot succeed because there was no reasonable expectation of profit in this enterprise. On a factual basis the net losses of $54,515 are staggering when compared with gross sales of $2,780. On a legal basis the reported cases support the proposition that in the circumstances of this appeal there was no reasonable expectation of profit. Before turning to the law, I will comment on relative amounts. In 1993, the revenue was $1,400 and total expenses including automobile were approximately $28,000. Ten per cent of $28,000 is $2,800; one-half of which is $1,400. The revenue in 1993 was only five per cent of the expenses. In other words, the revenue would have to multiply 20 times before it could match the expenses just on a break-even position, and that is accepting the expenses as computed by the Appellant.
[15]Looking at a similar comparison in 1994, the revenue was $1,000 and total expenses including automobile were about $12,800. The expenses are about 12 times the revenue, and so the revenue would have to increase by a multiple of 12 before it could match the expenses just to reach a break-even position. And for 1995, the position is even more extreme because the revenue was only $360. The expenses including automobile exceeded $15,000. Ten per cent of $15,000 is $1,500 and $360 is about one-fifth of 10%. Therefore, the revenue is only about 2½% of the expenses. When there is that big a gap between revenue and expenses in any enterprise, it is insurmountable.
[16]The Appellant and his wife both testified. I believe them when they said that they really wanted to make a lot of money in a short time. I have no problem with their credibility and believe them when they say that was their goal. I must conclude, however, that they were hypnotized by their goal because they appear to have been taken in by what I would call promoters of multi-tier marketing. Almost every venture they turned to faltered for some reason beyond their control because someone else saw something suspect in what they were doing. Whether the CBC broadcast was justified or not I do not know but according to the Appellant’s uncontradicted evidence, that CBC broadcast really hurt their chances of selling the water filter. Whether the provincial government should have ordered them to shut down Alberta Shopping Network, I do not know but it happened. The Appellant’s wife testified that she herself lost confidence in the JewelWay product when the item she bought performed so badly, when the gold disappeared and turned to black.
[17]The Appellant’s wife said that they were not fly-by-night schemes. I think she honestly believes that but, listening to the stories tumble out from both the Appellant and his wife, some of them sounded like fly-by-night schemes. I am suggesting that the Appellant and his wife were hypnotized by the prospect of turning a quick profit and they perhaps exercised less prudence in examining carefully the product which they were going to sell and the people who stood behind that product.
[18]In cases like this, the Courts usually begin with the decision of the Supreme Court of Canada in Moldowan v. The Queen, 77 DTC 513 where Chief Justice Dickson made the following statement at page 5215:
... 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 ...
Those are the words on which succeeding Courts have relied to say that if there is no reasonable expectation of profit, then there is no business. If there is no business, the taxpayer may have some kind of activity but it is not a business. Chief Justice Dickson further stated:
... In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. ...
I pause here because at one point in her evidence, the Appellant’s wife protested how sincere she was in her desire to make a profit. I asked her if she thought that anybody in the Court questioned her sincerity in wanting to make a profit. It is not a subjective matter of whether the Appellant alone or the Appellant and his wife wanted to make a profit. I think that deep desire was there. It is an objective test and not some standard that I have created. This is the Supreme Court of Canada speaking:
... In my view, whether a taxpayer has a reasonable expectation of profit is an objective determination to be made from all of the facts. ...
The first criteria mentioned is the profit and loss experience in past years. Those revenue and expense records for a five-year period speak for themselves. They show that the profit and loss experience has not been good. The revenue itself in five years went from $2,700 to $6,400, down to $1,400, down to $1,000, down to $300.
[19]The decision of the Supreme Court in Moldowan was applied with care by the Federal Court of Appeal in Tonn v. The Queen, 96 DTC 6001 and The Attorney General of Canada v. Mastri, 97 DTC 5420. The Federal Court of Appeal in Tonn allowed a taxpayer’s appeal after it had been dismissed in this Court. The facts in the Tonn case were important. At the end of the 1980s, Mr. Tonn and a number of associates purchased an apartment building in the eastern suburbs of Toronto. At that time, the real estate market was riding high in Metro Toronto and southern Ontario. Just after they purchased the building, the real estate market took a significant dive. They had difficulty renting the building. The profit they thought they would make out of this investment in real estate turned out to be a loss and they deducted the losses in computing income. The Minister disallowed the losses for the first three years and those were the three years that came under appeal.
[20]Before this Court, the appeals of Mr. Tonn and his associates were dismissed on the basis that there was no reasonable expectation of profit. The taxpayers appealed to the Federal Court of Appeal which was of the opinion that the Supreme Court decision in Moldowan ought not to be applied casually where the only issue was one of business judgment; and that Revenue Canada ought not to substitute its business judgment for that of the taxpayers. The Federal Court of Appeal allowed the Tonn appeals stating that it was only an issue of business judgment that went wrong for circumstances beyond the control of Mr. Tonn and his associates.
[21]It is a significant fact in the Tonn decision that Revenue Canada did not allow a start-up loss period. The three years under appeal in Tonn were the first three years when the taxpayers owned the apartment building. Tonn had cast a cloud on what I would call the general application of Moldowan. Some judges in this Court concluded that Moldowan did not have much application anymore and a number of appeals were allowed on the question of reasonable expectation of profit.
[22]In Mastri, the Federal Court of Appeal had an opportunity to review what it had said in Tonn. Robertson J.A. stated at page 5423:
... 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. ...
As I understand the decision in Mastri, the Moldowan test is to be used less assiduously where there is no personal element. I am satisfied that there was no personal element in the commercial activities of the Appellant and his wife but that does not mean the Moldowan test has no application.
[23]It is a question of fact in each case whether a taxpayer’s expectation of profit was reasonable or not in the circumstances. In this appeal, having regard to the Appellant's track record in 1991 and 1992 and looking at the following three years under appeal together, I find that there was no reasonable expectation of profit. The annual gross sales in the three years under appeal averaged less than $1,000. The aggregate expenses were 12 times revenue or 20 times or 40 times.
[24]There is an element of common sense here and I refer to a passage of my colleague Bonner J. in Mason v. M.N.R., 84 DTC 1001 where he said at page 1002, referring to the Moldowan test:
... Subjective optimism, no matter how sincere, does not meet the test. ...
He is referring to the test of reasonable expectation of profit. And in a case of my own, Maloney v. M.N.R., 89 DTC 314 at 315, I made this statement:
... 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. ...
I come back to the word “prudent”. The Appellant and his wife were sincere. They had a desire to make a profit but looking for a get-rich-quick plan I believe had them so mesmerized that they lost their sense of prudence in measuring whether it was reasonable to engage in these endeavours. For these reasons, I find that there was not a reasonable expectation of profit in the three years under appeal. The appeals are dismissed.
[25] I have one further comment. When the appeals officer was testifying and being cross-examined by the Appellant, she had gone through the expenses in a more detailed way than the original auditor and had analyzed certain expenses which she disallowed because there were no vouchers for them or she could not get an adequate explanation. In a sense, however, the Appellant was in a catch-22 position because, by disallowing certain expenses on the basis that they were personal in nature, the appeals officer was doing the Appellant a favour. By ruling out certain expenses, the appeals officer was bringing the revenue and allowable expenses closer and making it look a little more likely that there could be a reasonable expectation of profit.
[26]Listening to the appeals officer go through her analysis in each year, even after she had excluded the expenses which she would not permit to be taken into account in computing the loss, she was still left with a significant loss which was in her mind verified by expenses, all of which she was content as an auditor or appeals officer to accept. To challenge her disallowance of certain expenses is to say that the losses really should be higher, making a profit that much more difficult to achieve. Not to challenge her expense disallowance would leave unchallenged the fact that the bookkeeping seems to be something less than adequate.
[27]In that vein, I was disturbed to find that an expense of $3,500 which was disallowed turns out to have been paid in cash. People who engage in commercial enterprises in North America are obliged to follow what I would call standard business procedures. Generally speaking, in lawful businesses, expenses in the realm of $3,500 are not normally paid in cash. There has to be (if they are truly paid in cash) significant evidence to support the payment like a receipt in writing or the presence in Court of the person who received the cash, who will get in the witness stand and swear under oath that he or she was actually present and received in hand the $3,500 in cash. Or alternatively, bank statements showing that on a particular date $3,500 in cash was withdrawn from a particular account and therefore it might be inferred that that same amount of money was handed by one person to another.
[28] In the cross-examination of the appeals officer, I did not find that any of her decisions in analyzing and excluding expenses were undermined. Her evidence was fair, thorough and complete. She had performed an exhaustive analysis of the three taxation years that were before her. The appeals are dismissed, with costs
Signed at Ottawa, Canada, this 20th day of January, 2000.
"M.A. Mogan"
J.T.C.C.