CRA can deny business expenses after normal assessment period
Jamie Golombek: The CRA can deny expenses if taxpayer doesn’t appear to be running a business with a view to profit
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Business owners can generally deduct a variety of business expenses when calculating their net income for tax purposes. But if their expenses aren’t reasonable, or they don’t appear to be running a business with a view to a profit, the Canada Revenue Agency (CRA) reassessed the taxpayer’s 2011 tax return beyond the normal three-year reassessment period, and even reassess them beyond the normal reassessment period.
That’s what happened to a Newfoundland and Labrador taxpayer who was back in court in September to appeal a 2020 Tax Court decision. The CRA had reassessed the taxpayer’s 2011 tax return beyond the normal three-year reassessment period, reducing the amount of deductible business expenses he claimed, and removing the rental revenue and associated losses arising from the rental of three units to his kids at below-market rent.
The taxpayer opened a “financial consulting” business in 1999, with the stated objective of selling mutual funds and life insurance, yet it has never earned a profit and revenues have never been more than $1,900 in any tax year. In nine of those taxation years, his business revenues were less than $800, and his expenses have exceeded revenues in each year by a substantial amount.
The taxpayer reported his largest loss ever in 2011, a year in which he “gained no new clients … and earned one $27 commission.” Yet he deducted more than $19,000 of expenses when computing his 2011 business income.
“In comparison to his $27 commission, the expenses claimed are staggering — a multiple of more than 720 times his commissions,” a Tax Court judge said at the original trial. “At the lowest point of revenue, his claimed expenses reached their highest ever.”
The CRA reassessed the taxpayer’s 2011 return and allowed him to deduct expenses of $3,715, resulting in a business loss of $3,688. The CRA did not dispute that the taxpayer had a business, but it nonetheless disallowed $15,951 in expenses on the basis they were not incurred for the purposes of earning income or were not reasonable in the circumstances.
The taxpayer, who also worked as a guidance counsellor in Northern Canada for approximately seven months in 2011, described his client base as being about 35 people, two-thirds of whom were family and long-time friends.
The taxpayer testified that while he gained no new clients in 2011 and spent very little time on the business, he drove almost 4,600 kilometres for business purposes.
The taxpayer’s expenses for 2011 included significant meals and entertainment expenses, travel expenses, office expenses, motor vehicle expenses and capital cost allowances on vehicles. At the original trial, he was asked to explain the business rationale for a number of expenses and was unable to do so.
For example, when asked about the purchase of an iPod, the taxpayer “could not remember or explain how that was related to (his business).” Similarly, when questioned about the payment of a Canada Border Services Agency import fee, the taxpayer “could not remember or explain how the import fee was related to his business,” admitting he didn’t have any clients outside Canada.
The taxpayer also spent more than $200 on a category of expenses that included birthday cards, birthday cakes, children’s T-shirts, tickets to a Christmas show, ice cream and alcohol. He said they were gifts to clients and their children “to show appreciation” when questioned about the business rationale of these expenses.
The Tax Court judge concluded “these gifts were motivated primarily by personal relationships rather than business considerations … (and) were not incurred for the purpose of earning income.”
The judge similarly questioned the taxpayer’s meal expenses and travel costs. “I am skeptical that five trips … in December, including one in the week between Christmas and New Year’s and one on a Saturday, were necessary or even desirable,” the judge wrote. As to the size of the meal expenses, the judge concluded it was “not reasonable to spend hundreds of dollars on meals to earn a $27 commission.”
The judge ultimately denied all the taxpayer’s additional travel expenses, automobile expenses and office expenditures beyond what the CRA was prepared to allow, and confirmed the CRA’s reassessment.
The taxpayer also owned several rental properties that he rented to his sons. In 2011, he claimed significant losses on his tax return associated with these properties and failed to report the transfer of one of them to his son as a disposition for tax purposes. The Tax Court concluded the taxpayer’s rental activity involved a personal element and he was not pursuing a profit. This was supported by evidence that all three of the taxpayer’s tenants were his sons, and that he had charged rental rates below fair market value.
In the appellate court, the taxpayer argued (among other things) that the CRA shouldn’t have been permitted to reassess his 2011 return beyond the normal three-year reassessment period as the CRA had sufficient time to review all necessary documentation and complete any reassessment within the three-year period, and that CRA officials gave no valid reasons justifying the delay.
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The Federal Court of Appeal found there to be “no merit in this argument” since the language in the Income Tax Act is clear that the CRA is entitled to reassess a taxpayer after the normal reassessment period if a taxpayer made a “misrepresentation that is attributable to neglect, carelessness or wilful default or has committed any fraud in filing (his) return.”
After reviewing the Tax Court’s decision, the appellate court concluded the lower court was correct in finding that the taxpayer’s business expenses were unreasonable as a “commercially minded business person would not have incurred such expenses in the (taxpayer’s) circumstances.”
It also agreed with the Tax Court’s finding that the taxpayer’s rental properties were not a source of income, and that the taxpayer could therefore not deduct any associated rental losses from these properties from his income.
Jamie Golombek, CPA, CA, CFP, CLU, TEP, is the managing director, Tax & Estate Planning with CIBC Private Wealth in Toronto. [email protected]
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