When I was a kid, I remember being asked many times to clean my room. I never did a very good job of it. On one occasion, I recall my father sitting down with me and saying: "Tim, I want to educate you on how to do this properly." It was a polite way of saying: "If you do it like that again, you're in big trouble next time."
I can't help but think of the Canada Revenue Agency and a relatively new program the department has introduced. They call it an "education program" where the taxman sends a letter to certain taxpayers whom the department thinks may be a little aggressive in their tax filings. An excerpt from the letter reads: "The Canada Revenue Agency (CRA) has sent you this letter to give you information about certain claims you made on one or more of your recent income tax and benefit returns. This letter also gives you the opportunity to ask for an adjustment if you find that you incorrectly claimed some items on past tax returns."
Much like the message my father gave me, the real message being sent by CRA could be read as: "We think you might be doing something wrong, so think about coming clean now – before we decide to audit you." So, what does this mean for you this year when filing your tax return?
Those at risk
The people most at risk in this program are those who have been reporting recurring losses from their self-employment, rental or professional activities. If you report losses from these pursuits, you'll save tax because those losses can be applied against other types of income you might have.
The truth is, carrying on legitimate business, professional or rental activities can result in losses – particularly in the early years while you're still building up your revenue, and perhaps incurring higher costs than you will eventually. But, it's important to understand what the courts and the CRA have said about these losses so that you can be prepared to have an intelligent discussion with the taxman if you're one of the approximately 33,000 taxpayers who will receive an "education letter" this year, perhaps followed by an audit or at least some questions.
If you do receive an "education letter," don't panic. The courts have spelled out the principles that should be followed by the CRA, and taxpayers, when determining whether losses should be allowed. Understanding these principles and aligning your activities to them can put you in a good position to deal with the taxman if he comes knocking.
A few years ago, the Supreme Court of Canada set out these principles in the case of Stewart v. Canada (2002 SCC 46). The court recognized that our tax law will allow deductions – and losses – where a source of business or property income exists. The court established that if an activity is clearly commercial in nature, with no personal element to it, then a source of income exists. It's not a requirement that the activity produce a profit every year.
In fact, if you happen to be an incompetent business person and continually lose money every year in a legitimate commercial activity, it's not the role of the CRA to second-guess your business judgment and then disallow your deductions or losses. That is, when your activities are commercial in nature, CRA cannot disallow losses on the basis that there is no reasonable expectation of profit.
But what about a situation where the activity or endeavour can be classified as personal in nature, or having a personal element to it? In this case, the court established that it must be determined whether 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.
You may face a challenge, however, if the activity 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.
In light of the "education program" CRA is undertaking, you'd be wise to build the case today that your business, professional or rental activities are truly commercial in nature. The taxman will look at things such as: the profit and loss experience in past years, your training in the activity being carried on, your intentions when carrying on the activity, and the capability of the endeavour to show a profit.