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The deductibility of business/property losses, or non-capital losses, can be contentious subject of income taxes.  In what circumstances can the CRA refuse the losses? Let’s have a look

Income Tax Act and the deductibility of expenses

As explained in the Tonn v. R. (1995), 96 D.T.C. 6001, [1996] 1 C.T.C. 205, there are three specific sub-sections of the Income Tax Act that lay out the deductibility of expenses. The first is the taxation of business/property income:

ITA 9(1) - Subject to this Part, a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from that business or property for the year.

The mention of profit presupposes deductible expenses that can be used to reduce gross business/property income. As also mentioned in the Tonn decision:

Since the pursuit of business income is founded on the intention to earn profit, subsection 9(1) incorporates as a test for deductibility the intention to make profit.

The general limitation for deductible expenses is that the expenses are incurred for the purpose of gaining or producing income from a business or property:

ITA 18(1)(a) - In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

General limitation

(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 general limitation indicates that expenses are deductible as long as the purpose of them is to make business/property income. Once met, certain expenses are subject to specific limitations as laid out in ITA 18. Within this subsection, there is the implicit intention that the expense must be incurred with the intention of producing a profit [Mattabi Mines Ltd. v. Ontario (Minister of National Revenue), [1988] 2 S.C.R. 175, [1988] 2 C.T.C. 294].

The ITA also lays out that that expenses that are personal in nature cannot be deducted:

ITA 18(1)(h) personal or living expenses of the taxpayer, other than travel expenses incurred by the taxpayer while away from home in the course of carrying on the taxpayer’s business;

In many of the cases where the CRA refuses business/property losses, the agency will categorize the expenses that create the loss as personal in nature.

From the subsections mentioned above, there’s a clear theme of profits, or the intention of making profits being necessary for the recognition of income and expenses from a business or property. However, as we will see below, intention to make a profit is not enough.

Reasonable expectation of profits (REOP) argument

With almost all cases where business/property losses are disputed by the CRA, the reason is based on the concept of reasonable expectation of profit. As mentioned above, there must be an intention to make a profit in order for these losses to be deductible. However, in many cases contested by the CRA, the intention is not enough; there must be a solid business case made that the business/property is capable of turning a profit. This is what is commonly referred to as “reasonable expectation of profits” test.

The basis of the reasonable expectation of profits test is the Moldowan case [Moldowan v. R., [1978] 1 S.C.R. 480, [1977] C.T.C. 310, 77 D.T.C. 5213], where the Supreme court decided on farming losses for a hobby farm. The judge in that case laid out criteria to determine if there’s a reasonable expectation for profits. The criteria are:

·        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 exhaustive, however the requirement mentioned above of a viable business/property venture is clearly shown. This is commonly known as the Moldowan test and is the reference for many court cases based on disallowed business/property losses. As the judge in the Maloney case [Maloney v. Minister of National Revenue (1989), 89 D.T.C. 314 (T.C.C.)] mentioned when interpreting the Moldowan test:

The subjective, good faith, commercial hopes and dreams of an individual taxpayer do not confer upon his or her enterprise a reasonable expectation of profit if that enterprise does not meet the objective criteria of a prudent business in similar circumstances

The government does allow for some leeway of the reasonable expectation of profits test, and that is in the initial start-up phase of a business/property. The CRA will usually be more permissive of business/property losses in the first years of a new venture.  There is no uniform amount of time attributed to this start-up phase; it’s a case-by-case basis based on the facts of each case. In certain instances, such as the Tonn case above, the CRA did not allow for a start-up phase.

Stewart decision and the re-thinking of reasonable expectation of profit

The Moldowan decision mentioned above, and the guidelines set forth by that decision, were the reference when it came to the determination of business/property losses. However, a newer decision, Stewart v the Queen [2002 CSC 46], calls into question the REOP guidelines mentioned above.

Now we must approach the deductibility of these losses in two steps:

Step 1 - Determine whether the activity is personal in nature, or is it a legitimate commercial activity (this step follows the reasoning of the ITA mentioned above); and

Step 2 - Determine the deductibility of the expenses.

In the Stewart case, the question was on interest deductibility for a mortgage taken on rental properties in which no profit was made for several years. As per the decision of the Supreme Court, referencing the Ludco case:

 The plain meaning of s. 20(1)(c)(i) does not support an interpretation of “income” as the equivalent of “profit” or “net income”. Nowhere in the language of the provision is a quantitative test suggested. Nor is there any support in the text of the Act for an interpretation of “income” that involves a judicial assessment of sufficiency of income.

We see from the quote above that the Moldowan test for reasonable expectation of profit has been, for all intents and purposes, been eliminated. The emphasis now when it comes to these cases is to determine whether the venture is a bona fide commercial activity or personal in nature.