I was at a local hockey arena last weekend when I ran into an old friend who I hadn’t seen in a while. “Jack, I haven’t seen you for a couple of years! I heard that you’ve started a new business. Is that right?” I asked. “That’s right,” Jack replied. “This time it’s a non-profit corporation,” he continued. “I didn’t intend it that way, but it is.”
As it turns out, Jack is going to save big tax dollars because of his business losses. Many taxpayers have done the same thing in the past. Self-employment can be a great tax shelter, but you should understand the taxman’s – and the court’s – view of this. A recent court decision serves as a good reminder about the guidelines to follow.
The tax shelter
If you operate a business as a proprietorship (rather than incorporating the business), any losses you report from the business can be applied to offset other income you might be reporting on your personal tax return. Quite often, the losses stem from costs you’re incurring anyway. You might, for example, use your car in your business and claim depreciation (known as “capital cost allowance” – or CCA) on your car. You’re paying for a car anyway, so why not make it deductible? It’s not uncommon to experience losses in the early years of a business.
Brian Sumner is a gentleman who decided to start a business several years ago. Although he had a full-time job as an economist, he owned a vacation property in Victoria Beach, Man. (primarily a summer recreational area), spent weekends and vacations there, and felt there was a demand in that area for excavation services. So, Mr. Sumner registered a business called Sumner Mechanical. He turned his garage into a maintenance shop and bought a back-hoe, tractor and skid-steer loader.
Mr. Sumner reported losses on his tax returns in 2004, 2005 and 2006, and the Canada Revenue Agency disallowed losses amounting to $26,857, $29,648, and $32,710 for those years respectively. Most of the losses were created by claiming CCA on the equipment he had purchased. Mr. Sumner took CRA to court over the issue, and he lost his case. His story serves as a reminder as to what you need to do if you hope to have a small business (full- or part-time) to open the door to tax deductions.
This type of battle with the taxman is nothing new. Yet, in the last few years, the courts have spelled out the principles that should be followed by taxpayers – and the CRA – when determining whether losses from an activity should be allowed. In particular, it was the Supreme Court of Canada in the Stewart decision (2002 SCC 46) that set out the principles to consider.
The Supreme Court recognized that Canadian tax law will allow deductions where a source of business or property income exists. The question in every case, including Mr. Sumner’s case, is whether a source of income existed. Canada’s top court established that if an endeavour is clearly commercial in nature, with no personal element to it, then a source of income exists. This is not to say that the endeavour must produce a profit in any particular year.
Where an endeavour is commercial in nature, then there is no room for the CRA to disallow losses on the basis that there is no reasonable expectation of profit. Where the endeavour could be classified as being personal in nature, or having a personal element to it, then it must be determined whether or not the activity is being carried on in a sufficiently commercial manner to constitute a source of income. If so, then deductions and losses may be allowed.
A problem arises where the endeavour has a personal element to it and is not carried on in a sufficiently commercial manner. In this case, a source of income is not considered to exist, and losses won’t generally be tolerated by the taxman or the courts.
When deciding whether an endeavour is sufficiently commercial in nature, the taxman will look at many factors, including: the profit and loss experience in past years, your training in the activity being carried on, your intended course of action, and the capability of the endeavour to show a profit.
Mr. Sumner failed the commerciality test. Since he used his equipment more for his own personal property maintenance, advertised his business only seasonally, earned very little revenue, had little experience or training and lacked certain licences to operate some of his equipment on public roads, the courts ruled against him.