Date: 19990317
Docket: 97-2118-IT-G
BETWEEN:
PIERRE-YVAN AUBÉ,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
Reasons for judgment
Archambault, J.T.C.C.
[1] Pierre-Yvan Aubé is appealing notices of assessment for the 1993, 1994 and 1995 taxation years (relevant years) issued under the Income Tax Act (Act) by the Minister of National Revenue (Minister). The Minister denied the deduction of losses incurred by Mr. Aubé in the operation of a jewellery business. The Minister contends that Mr. Aubé had no reasonable expectation of earning a profit from the operation of this business, and this is the only point at issue.
Facts
[2] Mr. Aubé is a high school English teacher at a private institution in Drummondville. This activity occupies him only approximately 25 hours a week.
[3] Mr. Aubé is a single man with ambition: he wants to retire comfortably at the age of 50. With this objective in mind, he decided to go into business and, in 1984, he and Florence Castegan, became partners in acquiring a jewellery business located in downtown Drummondville. The store's owner wanted to sell because he wished to move to Valleyfield. Mr. Aubé did not hire an expert to conduct a profitability study with respect to this kind of business, but formed his own idea by visiting a number of jewellers in the region. In addition, the fact that Ms. Castegan had worked in such a business for some 20 years with her husband, who had since died, and that she appeared to be leading a prosperous life also encouraged him to go into the business. By Mr. Aubé's estimate, it was possible to make a gross profit of 40 to 60 percent in this kind of business.
[4] Although Ms. Castegan declared bankruptcy two years later and left the business, Mr. Aubé continued operating it alone. During the 1980s, Mr. Aubé moved his jewellery store twice, first to larger premises in the same neighbourhood, then, in 1987 or 1988, to the Place Charpentier shopping centre in St-Nicéphore, a municipality in the suburbs of Drummondville. Mr. Aubé hoped that at this shopping centre his business would be more visible and benefit from greater traffic. His store would be located near an IGA. Mr. Aubé also saw good potential in St-Nicéphore since residential construction was taking place around Place Charpentier.
[5] In addition to being a teacher and businessman, Mr. Aubé became a municipal councillor for the city of Drummondville in 1987 and held this position until 1995, devoting between 10 and 12 hours a week thereto.
[6] All his free time was given over to operating the jewellery store. He went there whenever he had some spare time. Such periods of spare time could be as long as two full days. Mr. Aubé worked at his store every Thursday and Friday evening and on Saturdays. He also worked Sundays on certain special occasions, in particular during exhibitions at the shopping centre. He estimated that he devoted 20 or 30 hours a week to his business.
[7] For the operation of the jewellery business, Mr. Aubé had three or four employees who worked in turns over a period of 50 hours per week. Except during the Christmas holidays, there was only one employee in the store at any one time. Mr. Aubé helped the employee during peak periods and also stood in for employees when they were on vacation. Out of his two-month school vacation, he set aside only two weeks to rest, but that still did not stop him from visiting potential suppliers for his store. Lastly, Mr. Aubé's parents helped him by picking up merchandise in Montréal and delivering jewels and watches that Mr. Aubé had had repaired by subcontractors. His parents received no remuneration for this work.
[8] At the start of the relevant period, the business's main assets were its inventory and fixed assets. The inventory's book value at the time was $105,613. The book value of the equipment was $23,648, and that of the leasehold improvements, $17,398, for total fixed assets of $41,046. At the end of the relevant period, the book value of inventory amounted to $109,431, and that of the fixed assets, to $64,310.
[9] Despite Mr. Aubé's efforts, there were only two years in which the jewellery business made a profit during the period from 1986 to 1997. Mr. Aubé's financial statements and the work sheets of the Minister's auditor provide the following figures for that period with respect to turnover, gross profit, profit (loss), rental expenses and advertising expenses:
Year Turnover Gross profit Profit Rent Advertising
(loss)
1986 n/a n/a $ 687 n/a n/a
1987 $50,795 $24,438 ($ 2,130) n/a n/a
1988 $46,003 $21,453 ($14,892) $ 5,975 $2,177
1989 $68,057 $32,210 ($11,400)[1] $ 6,350 $1,133
1990 $58,558 $26,947 ($20,107) $ 7,500 $1,609
1991 $63,397 $25,506 ($12,641) $ 7,778 $1,605
1992 $57,851 $25,162 ($19,692) $ 9,539 $ 916
1993 $69,015 $30,456 ($21,743)[2] $10,154 $ 909
1994 $64,454 $29,835 ($24,599)2 $10,986 $5,052
1995 $70,780[3] $34,692 ($15,077)2, $10,683 $1,660
1996 $71,7823 $36,475 ($ 4,231) $ 7,662 $ 752
1997 $62,113 $31,470 $ 888 $ 2,194 $ 985
[10] Mr. Aubé explained the lower turnover in 1990 and 1991 relative to 1989 by saying that the roadwork done on St-Joseph Boulevard, where the shopping centre was located, required customers living a kilometer away from the shopping centre to make an eight- or nine-kilometer detour.
[11] Mr. Aubé tried by various means to make his jewellery business profitable. He implemented a strategy to increase his turnover, adopting, for example, certain techniques for developing customer loyalty. In January 1992, he gave his customers membership cards providing them with certain benefits, in particular 15 percent discounts on the regular price of merchandise and free wrapping. He also introduced contests enabling his customers to win prizes, including a child's wagon. For the 1994 fiscal year he increased his advertising budget from $900 to $5,000.
[12] Mr. Aubé also attempted to find new sources of supply for lower-cost products. During trips to Florida and the eastern United States, he located suppliers who would supply him with products at lower prices than he was paying.
[13] In addition to his efforts to increase his turnover and gross margin, Mr. Aubé tried to reduce some of his fixed costs, in particular his hydro expenses: he reduced the number of light fixtures while enhancing the effectiveness of those that remained. He tried to reduce his long distance telephone expenses by acquiring a 1-800 line and making greater use of the facsimile machine to order his merchandise. In 1996, Mr. Aubé secured a six-month reduction of his rent from $890 to $500 a month. He even went as far as to close the store on Mondays to reduce salary expenses during the last two years of operation.
[14] Despite all his efforts, Mr. Aubé was unable to make his jewellery business profitable and had to resign himself to selling it. Steps were taken to this end in April 1996, but without success. In September 1997, Mr. Aubé made another attempt, giving Trans-Action Centre du Québec an exclusive mandate for three and a half months. If nothing materialized by the end of this period, Mr. Aubé would simply close his jewellery store, which is in fact what he was obliged to do on May 31, 1998.
[15] Mr. Aubé explained his jewellery store's failure in part by saying that the economic situation in the 1990s did considerable harm to this type of business. According to Mr. Aubé, there were some 27 jewellery stores in the greater Drummondville area between 1986 and 1989, of which only seven or eight are still in business today. In addition, the number of stores at the Place Charpentier shopping centre has fallen from 38 to six or seven. This decline may be explained in part by the fact that the IGA occupies more space and the shopping centre is increasingly leasing its premises to professional people rather than merchants.
Analysis
[16] As the Supreme Court of Canada held in Moldowan v. The Queen, [1978] 1 S.C.R. 480, it is essential that there be a source of income in order for a taxpayer to be able to deduct business losses. For the purposes of determining whether there is a source of income, a business exists only if an activity is profitable or is carried on with a reasonable expectation of profit.
[17] Some of the analytical factors used in making an objective determination as to whether a taxpayer has a reasonable expectation of profit are stated in a number of decisions, including Moldowan, supra, and Landry v. The Queen, 94 DTC 6624. In Moldowan, Dickson J. described these factors as follows at page 486:
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), 74 DTC 6193].
[My emphasis.]
[18] In Landry, Décary J.A. proposed the following factors at page 6626:
Apart from the tests set out by Mr. Justice Dickson, the tests that have been applied in the case law to date in order to determine whether there was a reasonable expectation of profit include the following: the time required to make an activity of this nature profitable, the presence of the necessary ingredients for profits ultimately to be earned, the profit and loss situation for the years subsequent to the years in issue, the number of consecutive years during which losses were incurred, the increase in expenses and decrease in income in the course of the relevant periods, the persistence of the factors causing the losses, the absence of planning, and failure to adjust. Moreover, it is apparent from these decisions that the taxpayer's good faith and reputation, the quality of the results obtained and the time and energy devoted are not in themselves sufficient to turn the activity carried on into a business.
[19] In Tonn v. Canada, [1996] 2 F.C. 73, at page 105, Linden J.A., like Dickson J. in Moldowan, notes that this list is not exhaustive:
These quotations suggest that the list of relevant factors is growing and that it may continue to grow. What this indicates is that a detailed look at the business in the context of its operations is what is required, and that reasonableness is to be assessed on the basis of all the relevant factors, both the already listed ones and any new ones that may be helpful.
[20] In assessing these factors, it is important that the courts use common sense and that taxpayers not be penalized retroactively when their business proves to be less profitable than expected. Linden J.A. stated the following in Tonn at pages 95 and 96:
The tax system has every interest in investigating the bona fides of a taxpayer's dealings in certain situations, but it should not discourage, or penalize, honest but erroneous business decisions. The tax system does not tax on the basis of a taxpayer's business acumen, with deductions extended to the wise and withheld from the foolish. Rather, the Act taxes on the basis of the economic situation of the taxpayer—as it is in fact, and not as it should be, subject to what is said below.
. . .
Consequently, when the circumstances do not admit of any suspicion that a business loss was made for a personal or non-business motive, the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgment may have been less than competent.
[My emphasis.]
[21] In Mastri v. Canada (Attorney General), [1998] 1 F.C. 66, the Federal Court of Appeal had an opportunity to clarify its thinking on this approach, at page 75:
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.
[My emphasis.]
[22] The case law is full of examples in which activities carried on by taxpayers represent a source of personal benefit. This is the case, for example, with the city dweller who loves horseback riding and purchases a farm to engage in horse breeding. Being able to deduct certain farming expenses might enable him to finance a secondary residence and the indulgence in an enjoyable sport at least in part out of tax savings. Similarly, there is a source of personal benefit when a taxpayer purchases a building and leases a portion of it to members of his family at a below-market rent.
[23] Applying the aforementioned approach to the facts of the instant case, I must note, as Linden J.A. did in Tonn at page 105, that the most important factor is the nature of the activity in respect of which the losses were deducted. The activity in this case is a purely commercial one. The evidence does not show that this activity entailed a personal benefit for Mr. Aubé or for members of his family. On the contrary, it is apparent from the evidence that his parents provided him with services without receiving any remuneration.
[24] Furthermore, the scope of the activity, the number of persons who took part in it and the context in which it was carried on are also important factors to consider in this case. This was not a store set up in the basement of Mr. Aubé's home and operated by him in his spare time. The pleasantly appointed store was located in a shopping centre; four employees unrelated to Mr. Aubé worked there; and the store had a large inventory.
[25] Mr. Aubé's sole motivation was to earn a profit from the business. He hoped to save enough money to be able to retire in comfort. He worked hard at operating the business successfully, but in vain. The financial difficulties moreover appear to have started when he moved his jewellery business from downtown Drummondville to St-Nicéphore. The fact that, over the years, the Place Charpentier shopping centre became more an office building than a shopping centre confirms that the new location was not the ideal place to operate a jewellery store. The IGA's expansion and the moving of its entrance also had a negative impact on custom at Mr. Aubé's jewellery store. In addition, traffic at the shopping centre was disrupted by roadwork in 1991. To all this must be added other factors beyond Mr. Aubé's control, such as the difficult economic situation in the 1990s.
[26] Mr. Aubé originally got involved in this business with a partner who had experience in the field. He also performed a cursory market analysis by consulting a number of jewellers in the area. When he decided to move the jewellery store to the shopping centre, it was not unthinkable that he might thereby improve its profitability. It is easy to see with hindsight that Mr. Aubé's hopes were unjustified and that he was unable to break even in the new premises.
[27] In support of his claim that Mr. Aubé had no reasonable expectation of profit during the relevant years, counsel for the Minister argued mainly that Mr. Aubé had incurred losses in 10 consecutive years. In my opinion, to determine whether there was reasonable expectation of profit, the situation must be considered at the start of each of the relevant years. At the start of 1993, Mr. Aubé had been suffering losses for six years, not 10.
[28] If a taxpayer accumulates losses year after year and has tried everything in order to correct the situation, but without success, there definitely comes a time when he must realize the obvious and recognize that the business cannot be made profitable and that there has ceased to be a reasonable expectation of profit. However, the Act contains no rule stating that business losses are no longer allowable in computing a taxpayer's income after three, six or nine consecutive years of losses. That determination is up to the court, which must assess all the circumstances to determine whether any expectation of profit has evaporated. The number of consecutive years in which losses have been incurred is merely one of the factors that must be considered.
[29] Mr. Aubé took corrective measures to make his business profitable, adopting in 1992 techniques to develop customer loyalty and substantially increasing his advertising budget in 1994. He also attempted to reduce his costs. In view of the type of business he operated during the relevant years, there was a likelihood that he could increase its sales and make a sufficient gross profit to cover all the expenses of the business. What was involved here was not a residential rental property subject to the control of a rent control board.
[30] Lastly, it is important to note that, even though Mr. Aubé was able to deduct his losses in computing his income, that represented a tax saving equal to approximately 50 percent of those losses.[4] That means that in a way Canadian taxpayers financed half of the losses. However, Mr. Aubé had to finance the other half out of his savings.
[31] What did Mr. Aubé stand to gain by paying $0.50 out of each dollar of losses during the relevant years? In some instances, there are other tax benefits that would explain such a situation. For example, in the rental property field, a taxpayer can deduct, year after year, rental losses which are 100 percent deductible, while hoping one day to resell the property and realize a capital gain, only 75 percent of which is taxable. From 1972 to 1987, only 50 percent of such gains were taxable. I am not aware that such a practice existed for businesses such as jewellery stores.
[32] Another example is that of certain seasonal businesses which are operated at a loss year after year in order to create jobs for family members, thus enabling them to be eligible for employment insurance benefits for a number of months. In the instant case, no member of Mr. Aubé's family was remunerated.
[33] Why would Mr. Aubé have persisted in spending $0.50 for each dollar of losses he incurred except for the ultimate purpose of making his business profitable and generating a profit. This is clearly a case in which the courts must act, in the words of Linden J.A. in Tonn, "sparingly and with a latitude favouring the taxpayer". The words of my colleague Bowman J. in Bélec v. Canada, [1995] C.T.C. 2809, 95 DTC 121, are also very apposite in the instant case. It would be most unfair for the tax authorities to want to participate in a taxpayer's profits but refuse to share his losses.
[34] Mr. Aubé ultimately realized that he could not earn a profit from the operation of his business. He first attempted to dispose of it, but was unsuccessful. He thus had to resolve to close it in 1998.
[35] I believe that the course of conduct Mr. Aubé adopted in operating his jewellery business was entirely reasonable and consistent with the conduct of business people. Consequently, I conclude that Mr. Aubé operated his jewellery business with a reasonable expectation of profit during the relevant years.
[36] For these reasons, these appeals are allowed and the assessments are referred back to the Minister of National Revenue for reconsideration and
reassessment on the basis that Mr. Aubé is entitled to the deduction of his business losses, the whole with costs.
Signed at Ottawa, Canada, this 17th day of March 1999.
"Pierre Archambault"
J.T.C.C.
[OFFICIAL ENGLISH TRANSLATION]
Translation certified true on this 18th day of January 2000.
Erich Klein, Revisor
[1] This figure includes a loss of $6,805 incurred upon the disposal of assets. No explanation was provided as to the nature of this loss.
[2] Approximately 25 percent of the losses incurred during the relevant years represent interest expenses of $4,881 in 1993, $4,502 in 1994 and $4,861 in 1995. For those three years, Mr. Aubé reported interest income of $5,232 in 1993, $4,109 in 1994 and $6,183 in 1995. Thus, if Mr. Aubé had used his savings instead of borrowing, he would have reduced his operating losses by approximately 25 percent.
[3] During the 1995 and 1996 fiscal years, Mr. Aubé provided management services to another business in the Drummondville area, for which he received approximately $9,000 in fees. These fees were included in the jewellery store's turnover.
[4] As Mr. Aubé's taxable income was $45,417 in 1993 and $38,075 in 1994, the marginal rate applicable to the losses might be less than 50 percent. For example, according to a tax guide prepared by KPMG, Peat Marwick Thorne, the marginal rate of a Quebec resident is 46.6 percent for taxable incomes between $38,740 and $50,000. The marginal rate applicable to the next $4,220 is 48.9 percent. Mr. Aubé was thus able to finance personally more than 50 percent of his losses.