Date: 19990514
Docket: 97-3402-IT-G
BETWEEN:
LYMAN KEEPING,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for judgment
Beaubier, J.T.C.C.
[1] This appeal pursuant to the General Procedure was heard at St. John's, Newfoundland on May 10 and 11, 1999. The Appellant testified and called Lou Collins. The Respondent called the auditor on the file, Ronald Kenny.
[2] The Appellant was reassessed for his 1993 and 1994 taxation years and losses claimed on account of his Amway distributorship were disallowed. He appealed.
[3] Paragraphs 8 to 10 and 12, inclusive, of the Reply, as amended, read:
8. In so reassessing the Appellant, the Minister relied on, inter alia, the facts admitted above and the following assumptions:
(a) the Appellant began operating the Activity in March, 1990;
(b) the Appellant does not plan any material changes to the Activity in the near future;
(c) the Appellant has no previous training or experience in the Activity;
(d) at all material times the Appellant was employed on a full time basis as a teacher;
(e) before starting the Activity, the Appellant prepared no business plan to determine if it would be profitable;
(f) there are no major start up costs associated with this Activity;
(g) there are no lease agreements or major capital expenditures required with this Activity;
(h) from 1990 to 1995 the Appellant reported the following losses from the Activity, respectively as business losses:
Taxation Year Gross Income Net Loss
1990 $ 325 ($4,649)
1991 $109,166 ($8,558)
1992 $261,637 ($5,312)
1993 $168,130 ($12,205)
1994 $145,174 ($14,358)
1995 $148,337 ($16,830)
(i) the gross income amounts as outlined in paragraph 8(h) above, include sales and performance bonuses and tool rebates, a portion of which are paid to others;
(j) revised to account for the bonuses and rebates paid out, the profit and loss statements of the Activity, including adjusted gross profit, for 1993 and 1994 are summarized as follows:
1993 1994
Sales $142,294.23 $108,648.58
Performance bonuses 25,836.74 36,526.29
Gross Income 168,130.97 147,174.87
Less:
Cost of goods sold $143,463.04 $112,015.58
Bonuses paid $9,586.29 21,670.77
GROSS PROFIT: $15,081.64 $11,488.52
Operating expenses: 27,286.69 25,847.26
Net Loss $(12,205.05) $(14,358.74)
(k) the Appellant did not have a reasonable expectation of profit from the Activity during the 1993 and 1994 taxation years;
(l) the expenses of the Appellant in respect of the Activity were not made nor incurred for the purpose of gaining or producing income from a business or property; and
(m) the expenses claimed in relation to the Activity were personal or living expenses of the Appellant.
9. In 1996 the Appellant reported the following loss from the Activity as a business loss:
Taxation Year Gross Income Net Loss
1996 $104,911 ($18,731)
10. In computing his losses from the Activity for the 1993 and 1994 taxation years, the Appellant claimed non deductible capital outlays and personal consumption expenses amounting to $6,939.53 for 1993 and $6,141.11 for 1994 as outlined in schedule "A" (forming part of the Reply to the Notice of Appeal);
...
12. The issue is:
(a) whether the Appellant had a reasonable expectation of profit from the Activity in the 1993 and 1994 taxation years; and
(b) if a reasonable expectation of profit is found:
(i) whether the expenses claimed were deductible; and
(ii) whether the resulting losses should be reduced to reflect the existing partnership.
[4] Assumptions 8(a), (b), (c), (d), (f), (g), (h), (i) and (j) are correct. The Appellant adopted Amway's plans and that became his business plan
[5] Mr. Keeping is in his 40's. He, his wife and two young children resided on the Burin Peninsula in Garnish, Newfoundland in 1990, where they still live and where he is a teacher. He has his B.A. and his M.Ed. degrees. He was also a teacher in 1990 when Mr. Noseworthy recruited him as an Amway distributor. Mr. Noseworthy is also a teacher. Mr. Keeping testified that he was attracted to Amway because he felt that his teacher's pension would not be sufficient for his retirement and that income from Amway residuals at the Emerald level would enhance his retirement income and protect his family.
[6] Mr. Keeping has also been able to purchase approximately 80% of his family's needs at wholesale through his Amway distributorship and he has attended out of province Amway Conventions at Niagara Falls and Atlanta, Georgia on a tax deductible basis. Thus, Amway offered him certain immediate personal benefits.
[7] As can be seen from the assumptions, Mr. Keeping made rapid progress. To become an Emerald distributor he had to establish three "legs" or groups with sufficient sales to become "Direct Distributors". By 1992 Mr. Keeping had established one leg. At this stage he lost the direct sales credit for that leg and became entitled to residuals from it. He then decided that he could stop devoting his time to that leg and use his time to develop a second leg. This approach was supported by his sponsor, Mr. Noseworthy.
[8] This decision was important because Mr. Keeping has retained his full-time job in Garnish as a teacher and could only devote about 10 to 15 hours each week (aside from travel time) to Amway. Garnish is a small town on the sparsely populated Burin Peninsula. It is about a four hour drive from St. John's, which has over 100,000 people and from Gander, a smaller city in the centre of Newfoundland. Thus, Mr. Keeping had to drive four hours each way to reach sufficient markets to establish legs of distributors. This took time and money. His time was limited due to his full-time job as a teacher. His income from teaching carried the losses he suffered as an Amway distributor.
[9] Almost as soon as Mr. Keeping began to devote his time to develop the second leg in 1993, his first leg began to disintegrate. It never has re-established itself and Mr. Keeping never developed the second leg.
[10] The major matter in dispute is whether the Appellant had a reasonable expectation of profit from the Activity during the years under appeal. In William Moldowan v. The Queen, in 77 DTC, 5213, at 5215 and 5216, Dickson J. said:
There is a vast case literature on what reasonable expectation of profit means and it is by no means entirely consistent. 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 following criteria should be considered: the profit and loss experience in past years, the taxpayer’s training, the taxpayer’s intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance. The list is not intended to be exhaustive. The factors will differ with the nature and extent of the undertaking: The Queen v. Matthews (1974), 28 DTC 6193. One would not expect a farmer who purchased a productive going operation to suffer the same start-up losses as the man who begins a tree farm on raw land.
[11] The history of the Activity is one of losses. The Appellant had no training or experience in accounting or business before he entered the Activity. He is middle-aged. Mr. Keeping had been, and remains, a teacher in Garnish, Newfoundland. His business training is what Amway representatives told him and these representatives had an interest in keeping everyone in the Activity, whether they suffered losses or not, since they were also Amway contractors entitled to residuals. His losses have continued to this day.
[12] Mr. Keeping is of the opinion that his first leg began to disintegrate in 1993 when numerous members failed to follow the Amway plan. In the Appellant's view this failure was due to personalities in the group which are simply inherent in gatherings of numbers of people. His only remedies were persuasion, which failed, and starting another group or groups which he testified he tried and is trying to do.
[13] Historically, there is no reasonable expectation of profit in the Activity after calculating capital cost allowance. However, that is a small part of his expenses.
[14] The Appellant's expenses for his Amway Activity plateaued at around the $25,000 to $27,000 range due to the small population market in the Burin Peninsula, where he resides. This necessitates travel and telephone long distance calls to take advantage of larger populations in St. John's, and elsewhere in Newfoundland. Mr. Keeping made these and longer drives more than once each week to develop his groups and participate in Amway conferences during the years in question.
[15] However, in cross-examination he agreed that another part of his problem is the profit margin allowed by Amway. At his expense level, which was consistent in 1993 and 1994, he had to gross well over $300,000 per year to break even. Even when a distributorship broke away and he obtained residuals, this problem remained and, as he has experienced, it is clear that travel and the telephone remain necessary in order to keep the groups active and successful. Lou Collins, an "Emerald" distributor, verified this when he testified that he is in personal or phone contact with Messrs. Keeping and Noseworthy, at least every two days throughout the year. By contrast, Mr. Keeping did not recognize the need for of constant contact to keep his established leg together and motivated. Rather his practice was to establish one group and then devote his limited time to establish a second group. However when he did so, the first group began to fail and ultimately did fail. Thus, it appears that establishing and maintaining three groups from Garnish will require two or three times the travel time and financial costs that Mr. Keeping has experienced. Mr. Keeping countered this possibility with reference to e-mail, the fax and Amway's new "Sapphire" programme and electronic and direct order systems. These systems and technologies came into effect beginning in 1997. Moreover, none of this accounts for the need to nurture and maintain his groups by constant personal contact from Mr. Keeping. This need for personal contact is the reason why even the greatest technology companies still put salesman on the road. To satisfy that need from Garnish will still require extensive travel and other costs.
[16] These functions indicate to the Court that, looked at reasonably, Mr. Keeping's efforts to develop and maintain the two or three groups necessary to attain the Sapphire level (which is new since 1994) or the Emerald level will increase Mr. Keeping's historical costs of $25,000 to $27,000 per year and the time required by a major amount. There is no evidence that the margin of profit has changed, and there is no evidence respecting the actual amounts, or percentages, or variances in percentages of residuals.
[17] Thus, in 1993 and 1994 there were two major problems for the Appellant: the very low margin of profit of the Appellant and the high costs which he would incur to develop and service second and third "legs" or groups from Garnish in order to achieve the Sapphire or Emerald status so as to obtain residuals from his distributors. It is clear from the Appellant's testimony that he does not appreciate the fact that an existing leg or group needs constant attention in order to maintain its success and that this will cost time and money. Nor did he appreciate this in 1993 or 1994.
[18] A number of factors prevented the Appellant from achieving a profit. They include:
1. The low margin of profit that Amway allowed him.
2. The small population or market base in the Burin Peninsula, near Garnish, which required him to drive for four hours to develop a market at great cost in both time and money.
3. His teaching job, which limited the time that he could devote to the Activity.
4. His mind set, which continues to this day, that he can leave an established "leg", or group, to fend for itself without servicing it and that it will then maintain itself.
Taken together, these prevented the Appellant from having a reasonable expectation of profit in 1993 and 1994.
[19] These were not start-up problems. The Appellant overcame his start-up problems in 1992. The business problems described paragraph [18] 1., 2. and 3. were there from the beginning. The fourth became evident in 1993 when Mr. Keeping began to develop his second group or "leg". He did not, or could not adapt and he has not yet done so. In fact, his gross sales have fallen rather steadily and markedly since then.
[20] As a result, the evidence has failed to rebut assumption (k) that the Appellant had no reasonable expectation of profit from the Activity in 1993 or 1994.
[21] The appeal is dismissed.
[22] The Respondent is awarded party and party costs. Because Mr. Collins' testimony applied to this and Mr. Noseworthy's appeal and because the argument could be condensed due to the similarity of the appeals, costs are fixed at one-half the usual tariff.
Signed at Ottawa, Canada this 14th day of May 1999.
"D.W. Beaubier"
J.T.C.C.