Taxpayers who invest in assets or schemes that may be profitable are naturally wanting or expecting to deduct those start-up costs against their other sources of income. Once the venture becomes profitable they know they will have to report the income and pay tax. Some of these pursuits, however, may be made more as a hobby or for fun then as a launch of a business. Examples include hobby farms, rental properties, and the like. The Canada Revenue Agency (“CRA”) is loathe to allow such deductions where there is no real expectation of profit. Why allow someone with money, that would otherwise be taxable, to invest in such an enterprise for enjoyment, without having to pay tax on the invested money and then allow it to be deducted from other income, thereby reducing their taxable burden?
No Real Expectation of Profit
The Income Tax Act defines what is considered as income, or a loss, from a business or a property in section 9. In simple terms, a profit is the income and a loss is the loss (expenses greater than revenue) in any given taxation year. However, CRA was always on the watch for hobby businesses and would deny losses where they felt there was “no real expectation of profit”. This was their test and was used to challenge what appeared to be nothing more than the pursuit of a pleasurable activity or the building of capital assets through the use of income that was by the investment, converted into an expense. The invocation of the test would mean that the venture was not a source of income under section 9 and the expenses were not deductible from income.
A New Test
The Supreme Court of Canada (“SCC”) in Stewart v. Canada dealt with the existing test in a situation where the taxpayer had borrowed money to invest in the purchase of condominiums with the long term expectation of profit from the rental revenue. His interest expenses were higher than expected. The investments were highly leveraged. CRA denied his attempt to deduct these losses – there being no real expectation of profit. The taxpayer appealed and lost all the way to the SCC. The SCC came to his rescue, and to the rescue of common sense.
The relevant sections of the Income Tax Act read as then and now as follows:
9. (1) Subject to this Part, a taxpayer’s income for a taxation year from a business or property is his profit therefrom for the year.
18. (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of (a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property.
The court rejected the “no real expectation of profit ” test as being one used too frequently without reference to the Income Tax Act to second guess the intentions of taxpayers and their commercial decisions. Courts do not make tax law, the Canadian parliament does. They laid out the proper test as follows:
The following two-stage approach should be employed to determine whether a taxpayer’s activities constitute a source of business or property income:
(i) Is the taxpayer’s activity undertaken in pursuit of profit, or is it a personal endeavour?
(ii) If it is not a personal endeavour, is the source of the income a business or property?
Pursuit of Profit or Personal Endevaour?
The first stage of the test is only relevant when there is some personal or hobby element to the activity. Where the nature of an activity is clearly commercial, the taxpayer’s pursuit of profit is generally established. Even when the taxpayer is engaged in a clearly commercial venture, meaning that the taxpayer subjectively considers the activity a business, it must be carried out within objective standards of businesslike behaviour. This means that even if running a business is the intention, it is possible to do so incompetently enough to not qualify as attempting to run a business. The objective factors listed by the Court are previous profit and loss experience, the taxpayer’s formal training, the intended course of action and the capability of the venture to show a profit.
Even if there is a personal element to the activity it can be carried out in a sufficiently businesslike way for the expenses to be deductible. As an example, imagine someone running a hockey league in a very organized way, but with the intention of being able to play hockey, not profiting from running the league.
The second branch of the test, considering whether the source of income is business or property, does not matter for establishing whether or not the activity is taxable, but for determining how that tax will be calculated, as business and property income have different rules for calculating income and deductions elsewhere in the Income Tax Act.
Deductability of the Expense
The deductibility of expenses, which presupposes the existence of a source of income, should not be confused with the preliminary source inquiry. Once it has been determined that an activity has a sufficient degree of commerciality to be considered a source of income, the deductibility inquiry is undertaken according to whether the expense in question falls within the words of the relevant deduction provision(s) of the Income Tax Act. To deny the deduction of losses on the simple ground that the losses signify that no business (or property) source exists is contrary to the words and scheme of the Income Tax Act. Whether or not a business exists is a separate question from the deductibility of expenses. To disallow deductions based on a reasonable expectation of profit analysis would amount to a case law stop‑loss rule which would be contrary to established principles of interpretation which are applicable to the Income Tax Act. As well, unlike many statutory stop‑loss rules, once deductions are disallowed under the “reasonable expectation of profit” test, the taxpayer cannot carry forward such losses to apply to future income in the event the activity becomes profitable
In sum, whether a taxpayer has a source of income from a particular activity is determined by considering whether the taxpayer intends to carry on the activity for profit, and whether there is evidence to support that intention. In this case, the taxpayer purchased four rental properties which he rented to arm’s length parties in order to obtain rental income. A property rental activity which, as here, lacks any element of personal use or benefit to the taxpayer is clearly a commercial activity. As a result, the appellant satisfied the test for source of income and is entitled to deduct his rental losses. Section 20(1)(c)(i) of the Income Tax Act, which permits the deduction of interest on borrowed money for the purpose of earning income from a business or property, is not a tax avoidance mechanism and, in light of the specific anti‑avoidance provisions in the Income Tax Act, courts should not be quick to embellish provisions of the Income Tax Act in response to tax avoidance concerns. In addition, since a tax motivation does not affect the validity of transactions for tax purposes, the appellant’s hope of realizing an eventual capital gain and expectation of deducting interest expenses do not detract from the commercial nature of his rental operation or its characterization as a source of income.
In the result, and in applying the new test, the taxpayer’s endeavour was to be considered a source of income form a business. This, in turn, allowed him to deduct his losses from the enterprise.
If you have questions about any of the above, or if you require advice with respect to tax disputes, contact the lawyers at Duncan, Linton LLP in Waterloo. Our tax lawyers regularly provide advice and guidance on communicating with the CRA and representation during appeals of CRA assessments, reassessments, and throughout any related tax litigation. Call us at 519-886-3340 or contact us online to speak to a member of our Tax Law Group.