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TAXFlash News from IncomeTaxCanada.net
:: CCRA's reasonable expectation of profit (REOP) replaced by new definition after Supreme Court of Canada ruling
:: During the 1960s a Lower Mainland taxpayer operated a horse racing “business” in addition to his regular employment. In calculating his taxable income the taxpayer sought to deduct certain losses from his horse racing activities. The Minister of National Revenue thought otherwise and wanted to deny the deduction of losses the taxpayer claimed in 1968 and 1969. The whole matter wound its way through the court system eventually ending up in the Supreme Court of Canada (SCC). In its 1977 decision, the SCC tossed the taxpayer’s horse racing losses stating “although originally disputed, it is now accepted that in order to have a ‘source of income’ the taxpayer must have a profit or a reasonable expectation of profit.” This seemingly innocuous case has since formed the basis of what has become known as the “reasonable expectation of profit” test (REOP for short). On its most fundamental level, the REOP test enabled taxpayers to deducted expenses and losses from a business or property within the parameters laid out in the Income Tax Act provided the taxpayer’s activity was carried on with a reasonable expectation of profit. Without a reasonable expectation of profit, CCRA was free to deny the deduction of expenses or losses from the activity or property. Not surprisingly, CCRA has relied heavily on REOP to deny taxpayers a deduction for various losses from business and property. For example, in recent years, CCRA has made considerable use of the REOP test in challenging rental losses claimed by taxpayers. Well, as our Prime Minister will undoubtedly attest, one should never expect things to remain the same. Witness two recent SCC decisions that appear to spell the end of REOP. In the first case, Stewart v. Canada, an experienced real estate investor purchased four condominiums with the intention of earning rental income. The taxpayer borrowed heavily to complete the purchase incurring significant interest expense in the process. As a result the taxpayer suffered sizeable rental losses that he attempted to deduct in the calculation of his taxable income. CCRA thought otherwise and denied the taxpayer’s deduction on the grounds that he did not have a REOP. The taxpayer lost his case at each step along the way until the case arrived on the doorstep of the SCC. There the SCC found the “REOP problematic owing to its vagueness and uncertainty of application, resulting in unfair and arbitrary treatment of taxpayers”. In place of REOP, the SCC laid out a two-stage approach to determine whether a taxpayer’s activities are a source of business or property income: 1. is the taxpayer’s activity undertaken in pursuit of profit, or is it a personal endeavour? 2. if the activity is not a personal endeavour, is the source of income from a business or property? According to the SCC “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 established. There is no need to take the inquiry any further by analysing the taxpayer’s business decisions. However, where the nature of a taxpayer’s venture contains elements which suggest that it could be considered a hobby or other personal pursuit, the venture will be considered a source of income only if it is undertaken in a sufficiently commercial manner. In order for an activity to be classified as commercial in nature, the taxpayer must have the subjective intention to profit and there must be evidence of businesslike behaviour which supports that intention. Reasonable expectation of profit is no more than a single factor, among others, to be considered at this stage”. But the SCC didn’t stop there going on to state “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”. Including the expectation of a future capital gain is new and wasn’t a factor to be considered under the old REOP test. The second case, Walls v. Canada, involved a group of taxpayers that formed a limited partnership to acquire and operate a mini-warehouse. By completing the $2.2 million purchase with $1 down it’s safe to say the acquisition was heavily leveraged. With interest applied to the balance at 24 per cent per annum, it’s also a sure bet the partnership lost money and piles of it. Once again the Minister sought to invoke REOP to deny the resulting losses. The SCC thought otherwise and, citing the tests laid out in Stewart, allowed the losses originally claimed by the taxpayers. In its decision, the SCC stated “it is self-evident that such an activity is commercial in nature, and there was no evidence of any element of personal use or benefit in the operation. Where, as here, the activities have no personal aspect, reasonable expectation of profit does not arise for consideration. Although the respondents were clearly motivated by tax considerations when they purchased their interests in the partnership, this does not detract from the commercial nature of the storage park operation or its characterization as a source of income”. In my mind, these cases represent a significant blow to CCRA’s reliance on REOP as a method of challenging the deduction of expenses and losses. It will be interesting to see how CCRA and the folks at the Department of Finance who draft our income tax laws respond.
Free Tax Advice Article Submitted to Income Tax Canada.net exclusively by Jim Maroney Official details about this and other topics on income taxes can be found in English & Francais at www.ccra-adrc.gc.ca Income tax information offered by www.IncomeTaxCanada.net is done so without endorsement by Canada Revenue Agency (CRA) - l'Agence du Revenu du Canada (ARC) (formerly Canada Customs and Revenue Agency - l'Agence des Douanes et du Revenu du Canada CCRA-ADRC and formerly Revenue Canada Revenu du Canada) or any Canadian government agency. The free advice is of a general nature for Canadian taxpayers seeking legal ways to reduce their personal and small business income taxes payable to the federal and provincial (or territorial) governments in Alberta, British Columbia, Manitoba, New Brunswick Newfoundland-Labrador, Northwest Territories, Nova Scotia, Nunavut, Ontario, Prince Edward Island, Quebec, Saskatchewan or Yukon. Specific taxation situations vary from taxpayer to taxpayer, province to province, territory to territory. The free tax advice here is only a general guide. Canadians should always seek individual guidance on accounting rules and tax laws from knowledgeable accountants and lawyers. To prepare your income tax return online and NetFile your Canadian income taxes electronically in English or Francais, please visit www.ufile.ca or www.impotexpert.ca websites. Additional information on financial products and services for Canadians can be found at www.CanadianCreditCenter.com. |
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