Management Services, Personal Motives, And The Pursuit Of Profit: Brown V. Canada - How The FCA Evolved The Source-of-income Test And Applied Its Decision In Paletta

• Published date: 07 June 2023
• Subject Matter: Strategy, Management
• Law Firm: Counter Tax Litigators
• Author: Peter Aprile, Natalie Worsfold and James Roberts

Thompson Reuters considers the authors "leading tax experts and litigators". The authors agreed to grant TR partial rights to this work. This article first appeared in TR's Tax Dispute and Resolution Centre.

In Brown v. Canada 2022 FCA 200, the Federal Court of Appeal restated the source-of-income test and applied the test to the taxpayer's management services activity. The FCA focused on the nature of the activity and clarified that, in situations where the activity lacks any personal element, the test requires courts to consider still whether the taxpayer aims to generate profit by engaging in the activity. Brown evolves the source-of-income test and attempts to avoid a regression to the pre-Stewart era and uncertainty.

Key Insights

Brown v. Canada 2022 FCA 200 offers three key insights.

1. Personal motives for an activity will not inherently transform the activity into a personal endeavour. The nature of the activity not the reason behind the decision to engage in it, constitutes the key factor.
2. Even when the activity lacks a personal element, the Court will consider whether the taxpayer aims to generate profit by engaging in the activity. However, the FCA does not intend to return to disputes about reasonable expectation of profit or taxpayer business acumen.
3. To comply with the FCA's guidance in Brown and avoid reverting to pre-Stewart uncertainty, courts should reject CRA and DoJ arguments that attack an activity's commercial nature unless the activity cannot create profit or loss similar to the Tax Court's finding in Paletta.
   
   

Background

Darrell Brown and Lyudmila Bezpala were a married couple.

Darrell and Lyudmila planned to open an art gallery in Toronto's Yorkville neighbourhood. Darrell and Lyudmila incorporated a numbered company to manage the gallery ("218 Inc."). Darrell owned 51%, and Lyudmila owned 49% of the common shares.

Darrell and Lyudmila hoped to open the art gallery in 2010. And they expected 218 Inc. to incur losses for the first five years. Darrell arranged for 218 Inc. to receive financing from Rotveil Technologies to provide 218 Inc. with the financial stability it needed in the early years. Lyudmila's brother was Rotveil's principal.

Bezpala-Brown Gallery ("BBG") opened in September 2010. But in 2010, Lyudmila became ill and could not carry out her BBG responsibilities because of her illness. In 2011, Rotveil stopped lending money to 218 Inc., and Darrell started contributing more time to BBG.

In January 2011, 218 Inc. passed a resolution to retain Darrell to provide management services. Darrell and 218 Inc. agreed that: (1) Darrell would receive a management fee equal to 20% of the amount by which BBG's annual revenue exceeded $100,000; and (2) Darrell would have the right to enter into a five-year management services contract to recoup losses if 218 Inc.'s revenue did not exceed $100,000 and did not pay Darrell any management fees ("the revenue-sharing agreement").

As expected, BBG experienced startup losses...