Determining Deductibility of Business and Investment Losses | FBC, Canada's Farm & Small Business Tax Specialist

Determining Deductibility of Business and Investment Losses

When determining deductibility of losses, you can look to two Supreme Court of Canada (SCC) rulings from 2002 to guide you.

Legitimate Source of Income

In its decisions in the Stewart and Walls cases, the SCC laid out principles for an approach to determine whether a taxpayer's activities represent a legitimate source of business or property income. Referred to as the "source test," the procedure involves 2 steps: 

  1. Is the activity undertaken in pursuit of profit, or is it a personal endeavor? 
  2. If it is not a personal endeavor, is the source of income a business or property? 

Where no personal element exists, and therefore the activity is clearly commercial in nature, the pursuit of profit is established and losses should not be denied. This part of the test is only relevant when some personal or hobby element exists for the activity. 

If the venture does have a personal element, it will be considered a source of income only if it is undertaken in a "sufficiently commercial" way. Hobby farms, some types of home businesses, or a personal residence on a farm might be sufficient to establish a personal element.

For the activity to be deemed sufficiently commercial, the taxpayer must intend to make a profit, and must show businesslike behaviour supporting this intention. 

A reasonable expectation of profit is only one factor among several to be considered at this point. Even when an investment has a personal element, if the activity demonstrates a businesslike manner and is intended to make a profit, it should still qualify for a tax deduction. 

The Stewart and Walls cases both involved real estate tax shelters. These shelters generated significant losses that the taxpayers deducted against other sources of income.

In the Stewart case, the taxpayer acquired highly leveraged condominiums and then rented them out. He incurred losses from the outset, primarily from interest expense related to the financing. In fact, the prospectus promoting the deal projected negative cash flow for 10 years, and tax deductibility of losses in the earlier years was part of the investment strategy. 

Canada Revenue Agency had disallowed the taxpayer's losses, saying he had no reasonable expectation of profit and therefore no source of income. However, the SCC reversed the decisions of both CRA and lower tax courts and allowed the losses. 

In the Walls case, two taxpayers had a limited partnership that acquired - also under highly leveraged terms - a mini-warehouse to conduct a storage park operation.

In this case the SCC also found, since the activities had no personal aspect, that the “reasonable expectation of profit” test was not relevant. The venture was definitely of a commercial nature. The fact that the taxpayers were driven by tax considerations to purchase their interests in the partnership did not negate the fact that the investment qualified as a source of income. 

The SCC also observed that external financing, in itself, is an indication the taxpayer is operating in a businesslike manner. In future this should favour taxpayers who borrow money to finance commercial activities that have some personal element. 

The "reasonable expectation of profit" (REOP) test used to be a favorite CRA tool for denying deductibility of certain business and investment and losses. The REOP test had its origins in a 1978 SCC case decision involving the application of restricted farm loss provisions to a taxpayer's horse-racing activities.

The original REOP argument said that business or investment losses could not be deducted if the activity did not have a reasonable expectation of profit and therefore could not be considered a source of income in the first place.

CRA had used REOP extensively to deny deduction of losses related to hobby farms, sideline businesses and rental properties. While there was no clear provision for REOP in the Income Tax Act (ITA) itself, it was a policy adopted by the tax authorities and often supported by the lower courts.

In its Stewart and Walls decisions, the SCC noted that the REOP test had become a broad-based tool used by the Canada Revenue Agency (CRA) and some courts to second-guess commercial decisions made by taxpayers, and that it violated the principle that courts should not be making rules relative to tax law.

If a person is operating a business, badly or otherwise, the SCC said it is not up to the tax authorities to deny the deductibility of expenses based on their judgment as to whether the business will eventually make a profit.

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