Tax Court of Canada Judgments

Date: 20010119

Docket: 2000-990-IT-I

BETWEEN:

DARLENE PELECHATY,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Hershfield, J.

Facts

[1]            Since 1993 the Appellant has undertaken the selling of silk plants and trees which she acquires under a bonus or commission arrangement from a supplier carrying on business under the name Totally Tropical Interiors.

[2]            The Minister of National Revenue ("Minister") reassessed the Appellant for her 1996 and 1997 taxation years, disallowing the losses which the Appellant had claimed as business losses arising from her sales activity. The Appellant has appealed these reassessments.

[3]            In making the reassessments, the Respondent asserted that the Appellant had no specific plan on how to increase revenue from the sales activity, that the sales activity had been suffering increasing losses since its inception, that there was no indication that the loss trend could be reversed, that the Appellant did not have a reasonable expectation of profit during the subject years and that the sales activity did not constitute a source of income for the Appellant in the subject years pursuant to sections 3 and 4 of the Income Tax Act ("the Act"). The Respondent also asserted that the expenses claimed in relation to the sales activity were personal or living expenses of the Appellant and, in the alternative to denying all of the losses for the subject years, the Respondent submitted that if the Appellant did have a reasonable expectation of profit from the activity and that if the activity constituted a source of income, then the losses should be limited in accordance with a schedule of allowed expenses set out in the Reply. Disallowed expenses under the Respondent's alternative position are approximately $2,010.00 in respect of the Appellant's 1996 taxation year and $5,828.00 in respect of her 1997 taxation year. At the trial, the Appellant agreed to accept the Respondent's alternative position including additional income receipts of $1,339.00, however, the Respondent continued to argue that the losses be disallowed in their entirety in the subject years on the basis that the activity giving rise to the losses had no reasonable expectation of profit.

[4]            The Respondent conceded in the Reply that the Appellant was sufficiently trained in respect of the sales activity and the products sold and that she spent sufficient time at the activity, at least relative to the volume of the business. Indeed, the uncontradicted evidence of the Appellant is that she spent 15 to 20 hours per week working at some aspect of her silk plant sales activity. While the Respondent refers to the sales activity as an "activity", I have no hesitation in referring to that activity as a business carried on by the Appellant. The Act defines "business" at subsection 248(1) to include an "undertaking of any kind" which must be taken to include, in my view, a sales activity sustained in a commercial context over a period of years. That is, the Appellant's undertaking is of a commercial nature and constitutes a business in my view.

[5]            From 1993 to 1997 the Appellant reported the following income (losses) from the sale of silk plants and trees:

Taxation                                  Gross                                       Net

Year                                         Income                    Expenses                Income (Loss)

1993                                         $24,216    $27,697    ($3,481)

1994                                         26,619     34,302     ( 7,683)

1995                                         19,491     26,279     ( 6,788)

1996                                         15,062     22,094     ( 7,032)

1997                                         15,479     24,780     ( 9,301)

The adjusted income under the alternative assessing position of the Respondent and agreed to by the Appellant is:

Taxation                                  Gross                                       Net

Year                                         Income                    Expenses                Income (Loss)

1996                                         $16,401    $20,084    ($3,683)

1997                                         15,479     18,952     ( 3,473)

[6]            The start-up of the business in 1993 was simply accomplished by signing up with Totally Tropical Interiors and by purchasing an opening inventory of silk plant products. Although the Appellant had a car for personal use, she acquired a suitable vehicle to transport her inventory. Home office equipment consisted of a photocopier. She maintained detailed ledgers of travel and a daytimer record of appointments and other attendances relating to the business.

[7]            Gross revenues from the business were commissions paid by Totally Tropical Interiors. Commissions were based on the Appellant's personal sales volumes and on the volumes of sales consultants that the Appellant personally sponsored as commissioned selling agents for Totally Tropical Interiors. To increase gross revenues, the Appellant had to increase her personal sales and/or establish a successful group of personally sponsored sales consultants. I believe that the Appellant put considerable effort into the development of the business. In 1993 when she commenced, she managed to sponsor four consultants, and in 1994 she added eight more sponsored consultants. Two of the consultants in 1994 had themselves sponsored at least one other consultant and had achieved monthly sales in excess of $150.00, being a recognized benchmark in the commission bonus arrangement. In 1995 ten more consultants were sponsored by the Appellant. In each of 1996 and 1997 only one additional consultant was sponsored by the Appellant and in each of those two years none of the Appellant's sponsored consultants had themselves sponsored additional consultants. Cumulatively, between 1993 and 1997, the Appellant had 24 sponsored consultants. However, as the above sales figures indicate (paragraph 5), the cumulative number of sponsored consultants did not make the business successful. Most of the Appellant's consultants were not actively involved in sales. For example, even in 1994, the highest gross revenue year, the Appellant acknowledged that, of the 12 sponsored consultants on her list at the time, only two were very active, one was modestly active and the rest were virtually inactive. Still, by the end of 1994, with only two very active consultants, the prospects may have looked promising, particularly if expenses declined (as they in fact did). Further, in that year, the Appellant reached "Branch Manager" status. If she could have sustained herself at that level, or advanced further, commissions would have been enhanced so, again, prospects may have looked promising.

[8]            The Appellant testified that although she had initially thought that she could earn $500.00 per month in commissions exclusive of her efforts, she acknowledged that she had not been successful. With hindsight and an objective analysis of the commission structure, this seems like a difficult objective to achieve but not wholly unreasonable. In 1996 the Appellant had at least six sponsored consultants who were somewhat active according to commission records of Totally Tropical Interiors (exhibit A-4). In 1997 the additional sponsored consultant seemed somewhat active as well but commissions from consultants grew in 1997 to only $1,605.00 from $1,339.00 in 1996. To achieve her objective, her sponsored consultants would have to have done more than three times the volume done by her sponsored consultants in 1997.

[9]            In 1997 the Appellant focused on increasing her personal sales in an attempt to generate a profit from the sales business. She testified that in 1996 she personally did 27 home demonstrations which she increased in 1997 to 39 home demonstrations. In spite of her increased personal efforts, sales dropped. She testified that her home demonstrations are in a farming community and that her sales reflect the general economic downturn. While home demonstrations were the main sales focus (implemented by arranging for hostesses to invite friends to the demonstration), the Appellant did actively pursue sales to commercial enterprises as a further means of increasing her sales. The Appellant acknowledges that she was unsuccessful in this attempt to establish commercial accounts given that most commercial enterprises were being serviced from major suppliers in major centres such as Vancouver.

[10]          There is considerable evidence that the Appellant made every effort to make a viable business out of the sale of Totally Tropical Interiors silk products. She actively and I think aggressively recruited sales consultants and made persistent efforts to train them and encourage their sales activities. Through advertising and promotions she was even successful in sponsoring a consultant in Ontario. She attended training sessions in Regina and travelled extensively in her area promoting her business. There is no doubt that she treated this as a commercial activity.

[11]          There was no personal element in these undertakings. While the Appellant's concession to accept the Respondent's alternative position may suggest some acceptance that some expenses were personal, I find this not to be the case, at least not in any material way. Expenses that are frequently associated with having a personal element were modest. For example, in 1996 and 1997 meals and entertainment claimed were $110.00 and $322.00 respectively. Expenses disallowed as per the alternative reassessing position (and agreed to by the Appellant) would appear more in the nature of what were asserted by Revenue to be unproven expenses and unreasonable vehicle expenses relating to miles travelled for business.

Analysis

[12]          The basis for the reassessments under appeal is set out in paragraph 2 above. In particular, the Respondent relies on the assertions that the Appellant did not have a reasonable expectation of profit during the subject years from the her sales activities and that such sales activities did not constitute a source of income for the Appellant in the subject years.

[13]          I have reviewed the common law reasonable expectation of profit test applied in Moldowan v. The Queen[1] to hobby farmers to deny losses and its companion test, that asks whether the activity generating the loss is a source of income. In that review I found that it can be worthwhile to look at these tests separately. The source of income test comes down simply, in my view, to a determination as to whether there is a genuine commercial enterprise. That is, is the activity pursued in a systematic, organized, business-like manner with a genuine profit-making motive?[2] If a genuine commercial enterprise does not exist, the courts have recognized the absence of a "source" and neither gains or losses from the activity are recognized. An example of an activity where the relevance of the degree of organization is critical in determining whether a source exists is gambling. Until such activity reaches a certain point of organized pursuit of profit, incomes and losses are simply not part of our taxation system.[3] If an activity is a genuine commercial enterprise, then incomes and losses are recognized as prescribed by the Act.[4] In Walls et al. v. The Queen (under appeal to the Supreme Court of Canada),[5] the Federal Court of Appeal found that unless there is something more to consider such as a personal element,[6] an ongoing commercial business is not subject to the reasonable expectation of profit test.

[14]          Even where an activity is found to be a genuine commercial enterprise and thereby a source of income, there has still been increasing resort to the reasonable expectation of profit test to deny losses where the enterprise in question has persistently incurred losses and threatens to continue to do so. While my review of the reasonable expectation of profit test has not convinced me that its application to deny losses to genuine commercial enterprises can be supported within the scheme of the Act, there is a body of common law that does apply it.

[15]          While the general rule in Walls is preferable, in my view, another approach as to when to apply the reasonable expectation of profit test, even where a genuine commercial activity exists, is described in the case of Kuhlmann et al. v. The Queen.[7] The Federal Court of Appeal in that case said, in effect, that, in respect of a bona fide business, the reasonable expectation of profit test would not be employed to deny a loss unless the expectation (that is, the profit motive) is "irrational, absurd and ridiculous".

[16]          In applying the test in this way, the Court accepted the description of the test in The Queen v. Matthews[8] at 6196:

I think it most unlikely that he would be engaged in "tree farming" if it were not for his abiding interest in forestry but I am convinced that he is bona fide engaged in it as a business, in the ordinary sense of that word, with the intention that it be profitable.

[17]          Applying the test in this way is, in my view, also consistent with applying it "sparingly" or "less assiduously"[9] where there is no material personal element in respect of the conduct of the activity. Personal elements such as the abiding interest in the activity would not, in themselves, be material for the purpose of applying the test in this way.

[18]          Before resorting to the reasonable expectation of profit test, the Court should also be satisfied that the income inclusions and more particularly the expense deductions claimed by a taxpayer in the creation of a loss, have been carefully scrutinized. While one would assume that this goes without saying, detailed expense audits in loss cases where the reasonable expectation of profit doctrine is applied, do not always happen. In reasonable expectation of profit cases there may be the temptation, if not a tendency, to accept losses as filed since expenses (to the extent of losses) will be denied if that test is successfully applied and will be so denied without a detailed analysis as to the appropriateness of particular expenses. The focus is shifted from considering the appropriateness of a particular expense to considering the profitability of the business as a whole as filed. In order to analyse the profit potential of a business, to the extent that it is ever appropriate to do so, such analysis can only be properly pursued if the income or loss determinations have been appropriately determined. In this case, an audit of expenses was done and I commend the officer of the Respondent that saw the need to do so.

Conclusion

[19]          In the case at hand, I find that although the Appellant incurred persistent losses, she was engaged in a genuine commercial activity with a genuine profit motive. She was engaged in a business, a "source" included in section 3 of the Act. Even though revenues declined in the subject years, her efforts to enhance sales actually increased. I have found that there was no material personal element in respect of the activity. An audit has been completed and adjustments to allowable expenses have been made and agreed to by the Appellant. Based on these findings and on the Walls decision, I find that the reasonable expectation of profit test does not apply. Since Walls is under appeal, I will go further. Based on the evidence before me and the Appellant's efforts in the subject years, I find the facts here do not support a finding that the Appellant's intended purpose and expectation to profit from the business was irrational, absurd or ridiculous. As such, I am satisfied that the reasonable expectation of profit test, to the extent it applies here at all, has been satisfied.

[20]          The appeals are allowed and are referred back to the Minister of National Revenue for reconsideration and reassessment to recalculate the tax liability of the Appellant in each of the subject years on the basis that the Appellant's revised losses in each of the subject years are as follows:

                                1996 - $3,683.00

                                1997 - $3,473.00

[21]          Given that the Appellant agreed to the Respondent's alternative position and given that the alternative position has prevailed, the appeal was essentially successful and on that basis costs are awarded to the Appellant.

Signed at Ottawa, Canada, this 19th day of January 2001.

"J.E. Hershfield"

J.T.C.C.

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