You might find it surprising but the CRA, the courts and taxpayers have been arguing a lot about what would seem to be a pretty straightforward question. The reason is simple: the Canada Revenue Agency does not want to allow a taxpayer to deduct losses year after year in a questionable enterprise. In the past, the tax department considered a business to be any activity that you conduct for a profit or a reasonable expectation of profit (REOP). If the business could not demonstrate that it could become profitable, CRA would deny the losses.
As a result of the 2002 Supreme Court of Canada decision, CRA now only considers the REOP concept if there is a personal element (or hobby) with respect to your business. Otherwise CRA will generally no longer question whether or not you actually run a business. If, however, there is a personal or hobby element in your business, then it must be determined if your enterprise is carried on in a sufficiently commercial manner as to indicate that there would be a source of income – and therefore a business. In this case the CRA would apply the REOP test. Overall, this is a major win for the taxpayer as many legitimate businesses have lost over the years their right to claim losses from what amounted to bad business decisions. The objective is to evaluate the commercial nature of your activity, not to judge your business acumen.
In practice it means that if your business is profitable, then you likely have very little to worry about – provided that your activity is not on account of capital (income on account of capital is normally a single transaction that results in a gain). If you have losses and there is some personal element involved, CRA would look at your business plan, whether anything happened that caused a business failure and what effort was made to solve the problem. If however your business is just a hobby, then your losses will not be tax deductible because you never really conducted your business in a sufficiently commercial manner.
The above represents the current assessing practices of CRA. However, the legislation that was proposed would have only allowed the deduction of business losses and other expenses where it would be reasonable to assume that you would realize a cumulative profit from the business during the time you carried on the business or could reasonably be expected to have carried on the business. But we still have to wait till new legislation comes into force…
To summarize, let’s review the general factors considered by CRA in assessing REOP as outlined in IT504:
● Business owner’s qualifications to run a successful enterprise
● Time devoted to the business
● Time spent in marketing goods and services of the enterprise
● Distribution activities: presentation of works, products, services to the public
● Revenues received and growth of revenues taking into account economic conditions, and other market changes
● Historical records of profits
● Type of expenses claimed and their relevance to the business.
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