Many years ago, the concept of “reasonable expectation of profit” was established and used as a tool by the Canada Revenue Agency (CRA) to target businesses that they felt were unreasonably claiming losses year after year. The idea was fairly simple – in order for losses to be deductible, they needed to be on account of a business that the taxpayer could reasonably expect would make a profit at some point in time. In the most basic application of this test, if a business was selling goods at less than it cost to purchase (or produce) them, there could be no expectation of profit. In practice however, it was rarely that easy to establish when a reasonable expectation of profit actually existed. For example, if a retail store was able to sell every item at $1.00 more than it cost them to buy, but on top of that they had to pay $100,00o in rent per year and $75,000 in salaries, is there a reasonable expectation of profit sometime in the future if they are only currently selling 50,000 items per year? If not, where do you draw the line as to when it becomes reasonable?
Over the years, the Courts watered down the CRA’s ability to use this tool. First came several decisions that basically stated the CRA could not assume that someone in business would always make good business decisions – they could not deny losses simply because taxpayers were bad businesspeople. Then in 2002, came a Supreme Court decision that said as long as there is no personal element to a business, and the nature of an activity is clearly commercial, there is no need to analyze the taxpayer’s business further, since such endeavors necessarily involve the pursuit of profit.
Earlier this year however, the Tax Court of Canada ruled in favour of the CRA on a case which on the surface appeared to be covered by the earlier Supreme Court ruling. In this case, a lawyer who was employed full time also had a part-time law practice on the side. She did not do any pro-bono work and charged all of her clients, but would “modify” her fees based on their ability to pay. The judge noted that based on the testimony, the lawyer was earning somewhere between $1.70 and $7.70 per hour and concluded that essentially the lawyer was trying to help out clients who could not afford to pay reasonable rates, and that while this may be commendable, it did not constitute a commercial venture where losses could be deducted year after year.
The CRA will continue to target businesses that incur repeated losses – especially in cases where those losses are being used to offset employment income. Where they cannot use the blanket expectation of profit test, they will go after the expense side, to ensure that they are valid business expenses and reasonable in the circumstances. If you are operating a loss business, it is therefore especially important to ensure that your documents are all in order and that you can show your expenses are justifiable.