Tax Court of Canada Judgments

Date: 20010119

Docket: 2000-2106-IT-I

BETWEEN:

DEAN SPEARING,

Appellant,

and

HER MAJESTY THE QUEEN,

Respondent.

Reasons for Judgment

Hershfield, J.

Facts

[1]            The Appellant sells Amway products and has done so since 1991.

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

[3]            In making the reassessment the Respondent asserts that the losses in the 1996 and 1997 taxation years were not start-up losses, that the Appellant had not taken any significant action to turn the sales activity around and make it profitable, 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 asserts that the expenses claimed in relation to the sales activity were personal or living expenses of the Appellant and, as an alternative position, if it is found that the Appellant did have a reasonable expectation of profit and source of income, that the Appellant was properly reassessed in accordance with paragraphs 18(1)(a) and 18(1)(h) of the Act on the basis that all of the losses in the subject years were personal or living expenses of the Appellant.

[4]            From 1991 to 1997 the Appellant reported the following income (losses) from the sale of Amway products:

                Taxation                                  Gross                                                       Net

                Year                                         Income                    Expenses                                Income (Loss)

                1991                                         $ 25,240 $ 28,237                   ($ 2,997)

                1992                                         185,040 191,433                   ( 6,393)

                1993                                         160,540 167,124                   ( 6,584)

                1994                                         147,250 173,975                   ( 26,725)

                1995                                         74,878     101,293                   ( 26,415)

                1996                                         72,976     98,044                     ( 25,068)

                1997                                         54,407     71,339                     ( 16,932)

                Total                                        $720,331 $831,445                  ($111,114)

[5]            The following loss was reported in 1998 (exhibit A-3):

                Gross Income:        $45,608.00; Total expenses $63,095.00;

                Loss: $17,487.00.

[6]            The Appellant testified that in 1999 gross revenues were $27,700.00, but that the business (transferred to a partnership in that year) showed a profit of $100.00. While the Appellant's complete 1998 income tax return was put in as an exhibit, the 1999 return that the Appellant had available was missing the Business Income Statement and was not submitted as an exhibit. However, that the front page of the 1999 return showed a business net profit of $100.00 was acknowledged by counsel for the Respondent and accepted by him as part of the Appellant's uncontradicted evidence. On the other hand, the absence of a statement of income and expense for the business in 1999 limits the usefulness of considering the net profit in that year in the analysis of the potential of the business in terms of it having a reasonable expectation of profit or of being a source of income. One acknowledged factor in the reporting of a profit was that the Appellant did not give his spouse a salary in that year; rather, she joined the business as a partner. The Appellant admits that he was aware of the assessments to deny losses when the 1999 return was prepared. In the circumstances, self discipline in the claiming of expenses may have contributed to the small profit or perhaps the Appellant sold off his closing inventory. This is mere speculation. I have no basis to find that the activity here became commercially profitable in 1999.

[7]            The sale of Amway products is done by way of a down line marketing system in which products are purchased by a distributor from Amway. The distributor might use a portion of the products for personal consumption but the objective would be for the distributor to sell the products at a retail level to a consumer or to resell the products to another distributor down the line. Sales down the line to persons who are themselves distributors are sales done at cost. Only sales for personal consumption to a person who is not a distributor are retail sales that allow the seller a margin of profit. Income from down the line sales to down the line distributors is derived from a complicated formula for bonuses paid by Amway to distributor groups.

[8]            The Appellant commenced his Amway distributorship in the 1991 taxation year. The Appellant testified that the Amway business plan has essentially not changed since that time except that recent changes have simplified accounting and administration. Down the line sales can now be credited to the upstream distributors without a series a purchase sales and deliveries actually having to be done at each distribution level.

[9]            As can be seen from gross sales, the Appellant's income peaked in 1993.

[10]          The Appellant testified that he had a business plan which was to have six distributors under him, which was all he felt he needed to sustain a profitable "Point Value" in the Amway commission hierarchy. Point Values are a percentage of the "Business Value" of products purchased from Amway by the Appellant and his distributor group. The Appellant appeared to have a good understanding of the complicated bonus system. Bonuses depended on the so-called "Business Value" of products purchased from Amway. Business Value is a variable percentage of the retail price of the products. The relevant percentage varies from product to product and from time to time. The Appellant gave credible evidence that he watched on a regular basis the Business Value of various products relative to their retail price and was thereby always current as to the actual commissions associated with the sale of different products.

[11]          In 1993, the Appellant had a group of six distributors which sustained for some six months a Point Value sufficient to give the Appellant the benchmark status of being a "platinum" distributor. While 1993 gross revenues were significant, a loss was still incurred. The loss was not such in the early years of the endeavour to justify a conclusion that it would never become a source of income. Indeed, the Appellant's business plan was not far off the mark at that point. Any growth in the group of six distributors could well have afforded the Appellant a positive source of net income.

[12]          Another aspect of the Appellant's business plan relates to the assignable nature of Amway bonuses. The Amway marketing system permits bonuses for so long as anyone in the distribution line is active. The Appellant believed that he could establish distribution groups over a period of time that would permit commissions without personal retail sales. Such commissions or residuals would be essentially expense free and are assignable to his family on his death. That is in theory, at least, the Appellant felt that his efforts were creating a source of income for his family in the future that was not dependent on his personal labour. His motive for incurring expenses and suffering losses was to build residual values. He testified emphatically that his efforts as an Amway distributor were an investment to generate a stream of income for his family that might be comparable to a retirement plan. However, the Appellant testified that residuals were only 4% of Point Values (a percentage of Business Values, which is a percentage of gross sales) and that if the 1997 sales were all calculated as residuals, the Appellant's income would be less than $2,000.00 per year. Even this modest residual might be difficult to sustain in a retirement or bequest situation. The investment (losses) over the seven preceding years to earn this example residual was over $100,000.00.

[13]          The Appellant acknowledged that he lost his "platinum" level distinction in 1994 and that by 1995 his group of six had shrunk and become less active. He testified that in 1995 a large part of his or the group's business was lost due to the closing of a main industry in Melford, Saskatchewan. This resulted in one or more of his group having to give up the Amway distributorship business. Further, one of his group was audited and resultant tax liabilities caused that group member to drop out.

[14]          The expenses claimed in the subject years are as follows:

                1996         1997

Gross profit (sales less cost of goods

and inventory adjustments)                $3,989.00                 $7,799.00

Expenses

Advertising            932.00      360.00

Delivery 1,594.00 1,170.00

Insurance               84.00        165.00

Interest 2,622.00 1,719.00

Meals & entertainment        1,084.00 1,067.00

Motor Vehicle        81.00        85.00

Offices expenses 1,004.00 966.00

Legal & accounting              250.00      250.00

Rent         25.00

Wages    7,601.00 7,601.00

Supplies 2,858.00 1,470.00

Travel      4,319.00 2,375.00

Telephone              2,671.00 2,519.00

                $25,125.00               $19,747.00

Capital cost allowance         378.00      276.00

                $25,503.00               $20,023.00

Motor vehicle expenses       3,554.00 4,708.00

Total Business Expenses     $29,057.00               $24,731.00

Net Loss                 ($25,068.00)            ($16,932.00)

Business use of home expense:

Property taxes        $1,718.00                 $1,848.72

Utilities 1,470.85 1,584.84

Water heater rental               65.40        64.20

Insurance               513.00      516.00

Mortgage interest                 3,827.29 3,734.99

Repairs & maintenance        58.63        91.68

                $7,653.42                 $7,840.43

Business use 20.4%              $1,561.30                 $1,599.45

[15]          The Appellant advised that he took out an inventory loan in 1993 in the approximate amount of $13,500.00 and that the loan had been reduced somewhat by the end of 1997. Interest expenses in 1996 of $2,622.00 and $1,719.00 in 1997 were for inventory loans.

[16]          The wage expenses deducted by the Appellant included a $600.00 per month salary to his spouse in each of 1996 and 1997. Travel expenses of $4,319.00 in 1996 and $2,375.00 in 1997 included flights for him and his wife to Colorado and a resort in Minnesota to attend Amway conventions or seminars. Office expenses, supplies and motor vehicle expenses were not well explained by the Appellant in his testimony. No capital cost allowance was claimed on a vehicle. The Appellant testified his vehicles were old models and that capital cost allowance would not have been material from the outset of the business. Home office expenses were claimed at 20.4% of the Appellant's annual home expenses (based on office and storage space used in respect of the Amway business relative to the total size of his home).

[17]          The Appellant testified that he worked at the business 15 to 20 hours per week.

[18]          The Appellant testified that, in the subject years, between 10 and 12 percent of the products acquired from Amway were used personally by him and his family in their home. More particularly, the Appellant estimated that his family's personal consumption of Amway products totalled some $6,800.00 per year in each of 1996 and 1997. That is, his family's personal consumption of Amway products in those years was approximately 9.5% of gross sales in 1996 and approximately 12.5% of gross sales in 1997. The Appellant attributes a good part of his family's consumption of Amway products to his business having left-over inventory. Amway would sell a distributor an ordered product in a box of 12 regardless that the distributor's customer may have only placed an order with the distributor for one such product. In this example the distributor would have a left-over inventory of 11 items. The Appellant testified that personal consumption was the result of having such excess inventories. The balance of closing inventories for years ending 1996, 1997 and 1998 were $26,460.00, $23,973.00 and $21,257.00 respectively. These closing inventories might suggest that Amway products lend themselves to normal inventory practices without personal consumption requirements. Since there are no benefits or imputed income, the only implication or inference to be drawn from such personal consumption is whether or not it contributes to the question of there being a personal element in the conduct of the Amway business by the Appellant. It also appears that the cost of goods sold includes inventory used for personal consumption. This clearly would be a non-deductible personal expense in my view regardless of the "left-over inventory" explanation given by the Appellant, which explanation I find does not detract from the expense being, inherently, a living expense.

[19]          In respect of any plan to turn the business into a profitable one, the Appellant testified that he has made every effort to reduce expenses and rebuild his distribution group. He points to difficult and unusual circumstances in the last few years that have resulted in the shrinkage of group sales relative to the good start that he had in 1993 and 1994. In this regard, I find the testimony of the Appellant unconvincing. From 1992 to 1999 gross sales declined steadily from $185,040.00 to $27,700.00. From 1995 to 1997 the decline was from $74,878.00 to $54,407.00 and in 1998 gross sales were $45,608.00. There is no evidence to support the contention of the Appellant that in the subject years he ambitiously invoked any plan to enhance sales or profitability. The slide in revenues in 1994 and 1995 were somewhat due to circumstances according to the Appellant's testimony but the absence of further explanation for further dramatic revenue reductions suggest to me that the Appellant's efforts in regard to the business were winding down. I am not prepared to find however that in the subject years there was no business at all. His sales activity still constituted a genuine commercial enterprise in those years.

Analysis

[20]          The basis for the reassessments under appeal is set out in paragraph 3 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 his sales activities and that such sales activities did not constitute a source of income for the Appellant in the subject years. In the alternative the Respondent asserts that the losses were personal or living expenses of the Appellant and that the Appellant was properly reassessed in accordance with paragraphs 18(1)(a) and 18(1)(h) of the Act.[1]

[21]          While many cases have articulated a source of income requirement to claiming losses, such requirement often seems to be only an alternate expression of the reasonable expectation of profit test laid down by the Supreme Court of Canada in Moldowan v. The Queen.[2] Cases that have treated the source of income test as an alternative expression of the reasonable expectation of profit test suggest that a business cannot exist without a reasonable expectation of profit. It is then axiomatic that if there is no reasonable expectation of profit, there is no business and if there is no business, there is no source of income. Such applications of the reasonable expectation of profit test are not well founded in my view.[3]

[22]          It is helpful to consider the source of income test distinct from the reasonable expectation of profit test. It is well accepted that only certain sources of income and loss are the subject matter of the Act. They are the four sources itemized in section 3. That windfalls, lotteries, gifts, inheritances and gambling, for example, are not sources of gains or losses for the purposes of the Act has never been questioned. They are not one of the four statutory sources, thus, any gross receipts are not income and any expenses are not deductible. Net gains or profits are irrelevant concepts if there is no source for the purposes of the Act. Sections 9, 18 and 67 have no application if there is no source for the purposes of the Act. To say that where there is no source, there is no loss recognition available under the Act is misleading if it implies that the "possibility" of loss or profit are relevant. Unlike the reasonable expectation of profit test, the source of income test is not results oriented. If the proper test (in these reasonable expectation of profit cases) is the source of income test, it should simply look to whether there is a genuine commercial enterprise – a business. When the taxpayer's approach to an activity becomes sufficiently systematic, organized and businesslike with a genuine profit motive so as to constitute rewards (if any) as rewards for effort extended in a commercial context for that purpose, then that activity becomes a business and its incomes and losses are recognized as income or loss sources for the purposes of 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.

[23]          Where the reasonable expectation of profit test is applied, even though an activity has been found to be a business and thereby a source of income, it is hard to understand how that test, as a common law test, can apply to deny losses. A "loss" denial rule does not deny expense deductions but rather denies that part of allowed expenses that exceeds the income from that source. Loss denial rules have been and should remain the domain of Parliament, not the courts.[7] Parliament can prescribe whether a particular loss is allowed, denied or source restricted. It can prescribe whether a source restricted loss can be carried back or forward, and if so, for how many years, to shelter income from the restricted source (but not other sources). A common law loss denial rule enjoys no such conceptual modelling opportunities. Consider a specific legislative expense denial and carry over provision that deals with an expense item often present in reasonable expectation of profit cases. Subsection 18(12) denies home office expenses to the extent they create a loss, however, it permits a carry over of such losses. How can this provision be applied when a loss has been denied using the reasonable expectation of profit doctrine? If the expenses claimed by a taxpayer filing a business loss include home office expenses, can such expenses or some part of them be carried over as provided in paragraph 18(12)(c) if the reasonable expectation of profit test has denied the loss? The benefit of the carry over seems to be lost. While the carry over would have only been available if there is income in the following year (perhaps an unlikely scenario in a reasonable expectation of profit case), this illustration still serves as an example of the potential difficulties of applying a common law doctrine within a comprehensive legislative model. Even if it is perceived by the courts that the model is not sufficiently comprehensive or fair or appropriate, judicial intervention should be discouraged, particularly in respect of a taxing statute.

[24]          The reasonable expectation of profit test has taken on a life of its own and has gone beyond the Supreme Court of Canada "hobby" farm endorsement of the test as set out in Moldowan. Now, common commercial endeavours are being attacked by questioning whether or not a taxpayer's endeavours are commercially exploitable. The test is being applied to tax shelters (for example, Walls) where express anti-avoidance provisions do not apply on their own terms. That is, it is increasingly being used as a broad common law anti-avoidance assessing tool without a legislative basis for doing so. Further, the application of the doctrine has changed the focus of the analysis from considering the deductibility of particular expenses as envisioned by the Act to circumscribing the application of a common law “loss” denial rule. Moving from expense denials contemplated by the Act to loss denials, was advocated in Moldowan but only in the context of hobbies. At page 5215, Chief Justice Dickson noted that in respect of the reasonable expectation of profit principle, which he accepted, "[i]f the taxpayer . . . is merely indulging in a hobby, with no reasonable expectation of profit, he is disentitled to any deduction at all in respect of expenses incurred" (emphasis added). Yet, in envisioning and describing three classes of farmers at page 5216, Chief Justice Dickson observed that "losses" sustained by a hobby farmer "are not deductible in any amount". In respect of a "hobby", the difference between denying expense deductions and denying losses is not worth clarifying if the hobby is not a source of income. The underlying premise in Moldowan in applying a loss denial rule (to Class 3 farmers) is that hobbies, pursued as non-business activities, are not sources of income. The Class 3 farmer sustains losses in the operation of a "non-business" farming activity and such losses are not recognized in our tax system. Whether any activity is a "business" – a source of income - should be a finding of fact in each case. This requires an examination in each case of the particular activity and requires consideration of whether there is a genuine profit motive and whether the commercial indicia of the activity are sufficient to constitute it a business. In some cases, such as the case of a Class 3 farmer, the activity will be wanting in respect of these factors and will be found to be a hobby or similar pastime that is not a business.

[25]          One of the prevailing assumptions in reasonable expectation of profit cases is that but for applying that test, the only reasonably foreseeable outcome of the activity would be an inappropriate tax deduction of expenses that would have been incurred (for personal reasons) even if the activity had not been undertaken. If the activity only breaks even in other respects, such expenses generate losses which offset other income to create a tax profit. In my view, where the activity has been found to be a genuine commercial enterprise (or found not to be a "non-business" in the Moldowan sense), it should not be necessary to look beyond the expense deduction provisions of the Act to deal with this concern. Indeed, section 18 alone should suffice.[8] For an expense to be deductible, paragraph 18(1)(a) requires it to have been incurred for the purpose of gaining or producing income. The intention of the taxpayer that he or she "could generate a taxable income sometime in the future" governs the application of this test (Mattabi Mines v. Ontario[9]). This construction of paragraph 18(1)(a) of the Act is cited with approval by the Supreme Court of Canada in 1994 in Symes v. The Queen[10] at page 6013. The purpose test was applied on a subjective basis in Mattabi Mines to reject the notion that there had to be a casual connection between the expenditure and the income. Still, support can be found in Symes for reading objective standards into subjective tests such as the purpose test in paragraph 18(1)(a):

As in other areas of the law where purpose or intention behind actions is to be ascertained, it must not be supposed that in responding to this question, courts will be guided only by a taxpayer's statements, ex post facto or otherwise, as to the subjective purpose of a particular expenditure. Courts will, instead, look for objective manifestations of purpose, and purpose is ultimately a question of fact to be decided with due regard to all of the circumstances. [11]

That is, in cases where "reality" does not conform to stated purposes, expenses can still be denied under paragraph 18(1)(a). That is, applying the Act on its terms, can permit not only scrutiny of the genuineness and credibility of a taxpayer's intentions to carry on a commercial enterprise permitting a finding as to whether or not there is a source of income, but it can permit scrutiny of the genuineness and credibility of a taxpayer's purpose in incurring a particular expenditure. This is particularly true in cases where there are personal elements associated with the activity or the particular expenditure. When personal elements are considered in the search for objective manifestations of the purpose for incurring particular expenses, there should be little need to invoke a reasonable expectation of profit test as a means of introducing objective testing of a taxpayer's purpose in carrying out an activity or incurring an expenditure in pursuit of it.[12]

[26]          In addition to the possibility of applying paragraph 18(1)(a) to more closely scrutinize a taxpayer's purpose, more resort in these types of cases might also be had to paragraph 18(1)(h) of the Act which denies the deduction of personal living expenses. There is clearly room in the application of this expense denial provision for findings in reasonable expectation of profit cases that particular expenses incurred are simply personal expenses. Again, applying the Act on its terms, permits scrutiny as to the true nature of an expense.

[27]          Based on the foregoing, the common law test of reasonable expectation of profit should, in my view, have limited application to cases where there is no business - no genuine commercial enterprise. Still, there is a body of common law that does apply it, even where an activity is found to be a genuine commercial enterprise. Such cases should, in my view, be limited to circumstances described in Walls. Alternatively, another approach that applies a reasonable expectation of profit test (even where a genuine commercial activity exists) on a very limited basis, is described in Kuhlmann et al. v. The Queen.[13] In that case, the reasonable expectation of profit test would not be applied unless the expectation of profit (i.e. the subjective intention to earn income) was, objectively, "irrational, absurd and ridiculous".

Conclusion

[28]          The Appellant's sales activity in the case at bar is clearly a business. It is not a hobby or "non-business" in the Moldowan sense. The worst that can be said is that the business in the subject years evidences a dramatic slow-down in sales and that the trend in recent years evidences that the Appellant might be winding down his business and spending less time at it. However it was still, in the subject years, a genuine commercial enterprise. While his drive for profit may have diminished in the subject years, I accept his testimony that the undertaking was still being pursued with a genuine intention to profit. I also find that there is no material personal element in this case that would dissuade me from applying Walls. Accordingly, I find that the reasonable expectation of profit test does not apply here. Since Walls is under appeal, I will go further. Based on the evidence before me I am satisfied that the facts here do not support a finding that the Appellant's intended purpose and expectation to profit from the business in the subject years 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. That does not mean to say that the Appellant's credibility in respect of his stated purpose for incurring a number of expenses is not suspect. Indeed, the more sales decline and the more the activity in the pursuit of sales decline, the more suspect I am of the Appellant's reasons for incurring a number of expenses. Further, while I have found that there was no material personal element sufficient to alter my view that the sales activity in the subject years was a genuine commercial enterprise, I am not thereby, precluded from finding certain expenses to be personal expenses.

[29]          In examining particular expenses, it would have been helpful if the Respondent had conducted a detailed audit of this business for the years in question. That was not done. This reflects a regrettable tendency of the Minister to essentially accept, in these cases, expenses and losses as filed and to rely on the reasonable expectation of profit test to rectify any inappropriate claims. Accepting expense claims and shifting the focus of examination to whether an activity is commercially exploitable is a lazy and unacceptable practice. The first task in the reassessment process is surely to determine whether the taxpayer has calculated his income or loss correctly in accordance with the terms of the Act. Indeed, to seek to apply a reasonable expectation of profit test without first determining what the true income or loss of the activity is, makes little sense. But for the Respondent's alternative position set out in its Reply to the Notice of Appeal that the losses reflect expenses that are personal and living expenses of the Appellant, I would be tempted to allow the appeal in full on the premise that if expenses have not been challenged, they must be permitted. Further, my having to review the deductibility of particular expenses in order to uphold all or part of the subject assessments is to search for facts supporting a new assessing position. If that is the exercise, then the onus is on the Minister to establish that the Appellant's expense claims should be denied. In any event and regardless of these concerns, I am satisfied that a number of expenses here are personal expenses or expenses incurred without the genuine purpose of earning income. I also question the reasonableness of some of the expenses given that in the subject years the business here seems to be in at least the initial stages of winding down.

[30]          Based on the evidence produced at the trial, revenues and expenses can be adjusted on the following basis. In both years, cost of sales were overstated to the extent they included inventories for personal use. It is my understanding from evidence at the trial that no such adjustment was made and that profits were thereby understated by $6,553.00 in 1996 and $5,826.00 in 1997.[14] Based on the absence of evidence to the contrary and my doubts as to the genuine purpose of the expenditures, I find that meals and entertainment expenses in this case were personal. I find wages to the Appellant's spouse as being unreasonably high based on the substantial reduction in sales activity in the subject years versus earlier years (when the payments commenced) and on the lack of evidence that her wages were reasonable. I would deny 50% or $3,600.00 in each of 1996 and 1997 in respect such wages.[15] The Appellant could not provide any explanation for the expenditures in respect of supplies and could not differentiate between what might have been included in office expenses from what he might have included in supplies. On this basis I would deny expenses claimed in respect of supplies ($2,858.00 in 1996 and $1,470.00 in 1997). I would deny travel expenses on the basis that, in my view, they were holiday oriented trips taken with his spouse. It is simply not credible to me as business is winding down that it was an income earning purpose that drove the Appellant to take these trips. Accordingly, I would deny the entire travel expense in both years. Further, if after these adjustments, there is still a loss that would be increased by having home office expenses ($1,561.00 in 1996 and $1,599.00 in 1997), same would be denied under subsection 18(2).

[31]          Accordingly, the appeals are allowed without costs and referred back to the Minister for reassessment on the basis of the adjustments described in paragraph 30 above which I have calculated will permit losses in 1996 of $5,093.00 and losses in 1997 of $995.00.

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

"J.E. Hershfield"

J.T.C.C.

---