Information for Canadian Small Businesses: Chapter 5 – Income Tax

From: Canada Revenue Agency

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This chapter introduces you to the process of reporting income and paying income tax on your business profits. We explain how to account for the amount your business earns and the kind of income you have to report. This chapter explains what expenses you can deduct. It also tells you how the three most common business structures pay tax.

Accounting for your earnings

Generally, you have to report business income using the accrual method of accounting. Farmers, fishers, and self-employed commission agents can use the cash method or the accrual method to report income, but not a combination of both.

The accrual method

Under the accrual method, you have to report income in the fiscal period you earn it, regardless of when you receive the amount for payment.

You can deduct allowable expenses in the fiscal period that you incur them, whether or not you pay for them in that period. Incur usually means you paid or will have to pay the expense.

The cash method

If you use the cash method, you report income in the year you receive the amount whether it is in cash, property, or services. You deduct allowable expenses in the year you pay them. If you are a farmer, fisher, or self-employed commissioned sales agent, you can use the cash method.

For more information about the cash method, see Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

How to keep sales and expense journals

You should keep a day-to-day record of your receipts and expenses. Keep this record with your duplicate deposit slips, bank statements, cancelled cheques, and receipts. This will support your sales income and expense claims.

How to record your business expenses

You can generally deduct business expenses only if you incur them to earn income. If you claim expenses, you have to be able to back up the claim. You do this by keeping all your business-related vouchers and receipts, and record your expenses in a journal, a computerized file, or a software accounting program.

Fiscal period for income tax purposes

You have to report your business income on an annual basis.

For sole proprietorships, professional corporations that are members of a partnership, and partnerships in which at least one member is an individual, professional corporation, or another affected partnership, your business income is generally reported on a calendar-year basis.

If you are a sole proprietor or if you are in a partnership in which all the members are individuals, you can elect to have a non-calendar-year fiscal period. To make this change, complete Form T1139, Reconciliation of 2017 Business Income for Tax Purposes. For more information, see Guide RC4015, Reconciliation of Business Income for Tax Purposes.

A corporation's tax year is its fiscal period. A fiscal period cannot be longer than 53 weeks (371 days). A new corporation can choose any tax year-end as long as its first tax year is not more than 53 weeks from the date the corporation was incorporated or formed as a result of an amalgamation. The corporation has to file its income tax return within six months of the end of its fiscal period. When the fiscal year ends on the last day of the month, the return is due on or before the last day of the sixth month after the end of the tax year. When the fiscal year ends on a day other than the last day of the month, the return is due on or before the same day of the sixth month after the end of the tax year.

It is a good idea to become familiar with the rules of fiscal periods when planning your business. For more information, see Guide RC4015, Reconciliation of Business Income for Tax Purposes, and Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

Note

If you are a GST/HST registrant, how you set up your fiscal period-end for income tax purposes may affect your GST/HST reporting periods, filing, and remitting due dates. For more information, see Guide RC4022, General Information for GST/HST Registrants.

Income

This part of the guide gives an overview of the business income that you account for in your business records.

Types of income

You may receive income from sources other than your sales. If they relate to your business, you have to include them in your business income.

What is business income

Business income is income you earn from a profession, a trade, a manufacture or undertaking of any kind, an adventure or concern in the nature of trade, or any other activity you carry on for profit and there is evidence to support that intention. For example, income from a service business is business income. Business income does not include employment income, such as wages or salaries received from an employer.

You must include all your income when you calculate it for tax purposes. If you fail to report all your income, you may pay a penalty of 10% of the amount you failed to report after your first omission.

A different penalty may apply if you knowingly, or under circumstances amounting to gross negligence, participate in the making of a false statement or omission on your income tax return. The penalty is 50% of the tax attributable to the omission or false statement (minimum $100).

How to account for your business income

Business owners have to provide information about their business income and expenses.

Although we accept other types of financial statements, we encourage you to use any of the following forms that apply to you:

We have designed the forms to accommodate the most common income and expense categories used in business. You can use the categories included on the forms when you start up your own accounting records.

You also have to record as income any amount credited to your account or set aside for you as payment for providing goods and services. This includes amounts credited to your accounts as offsets against an amount you owe.

You have to support all income entries in your records with original documents—sales invoices, cash register tapes, receipts, fee statements, and contracts. Keep these supporting documents in calendar order or numerical order. Keep them available in case we ask to see them.

You must keep a separate record of your income from all other sources, such as professional fees and income from property, investments, taxable capital gains, estates, trusts, employment, and pensions.

Bad debts

If, during the year, you received any amount that you wrote off as a bad debt in a previous year, you have to include that amount in your income for the current year.

For more information, see archived Interpretation Bulletin IT-442R, Bad Debts and Reserves for Doubtful Debts.

There may be GST/HST implications on the recovery of bad debts. For more information, see Guide RC4022, General Information for GST/HST Registrants.

Reserves

You have to bring any reserve you claimed in a previous year back into income the next year. The Income Tax Act lets you take a new reserve based on your circumstances at that time.

For more information, see archived Interpretation Bulletin IT-154R, Special Reserves.

Vacation trips and awards

If you received vacation trips or other kinds of awards (such as jewellery or furniture) as a result of your business activities, you must include the value of these awards in your business income.

Vacation trips and awards may have GST/HST implications. For more information, see Guide RC4022, General Information for GST/HST Registrants.

Government grants and subsidies

If you get a grant or subsidy from a government or government agency, you have to report it as income or as a reduction of an expense. Generally, a grant or subsidy:

  • increases your income or reduces your expenses
  • relates to an income deficiency
  • relates to specific expenses

For example, if you are a farmer and you received a payment to subsidize your income in a drought year, you would add the payment to your income. However, if you are a business that receives a government employment grant to allow you to hire more students, you would generally deduct the amount of the grant from the wage expense you are claiming.

Government assistance that enables you to acquire capital property does not increase your net income. However, for depreciable property, you reduce the capital cost of the property by the amount of assistance received. For other capital property, reduce the adjusted cost base accordingly.

For more information, see archived Interpretation Bulletin IT-273R2, Government Assistance – General Comments.

Surface rentals for petroleum or natural gas exploration

If you have land that you usually use in your farming or business operation, and you are leasing it out for petroleum or natural gas exploration, you may have to include the leasing proceeds in your income as a capital receipt or an income receipt.

Surface rentals for the exploration of petroleum or natural gas may also have GST/HST implications. For further information, you may call 1-800-959-8287.

For more information, see archived Interpretation Bulletin IT-200, Surface Rentals and Farming Operations.

Rental income

Rental income can be income from property or income from business. For income tax purposes, income from rental operations is usually income from property.

The rental of real property may have GST/HST implications. For more information, see Guide RC4022, General Information for GST/HST Registrants.

Do not include rental income, whether from farm property or real estate, with your income from business or farming. You have to report it separately on your tax and benefit return.

For more information on rental income and how to report it, see Guide T4036, Rental Income.

Barter transactions

A barter transaction takes place when two persons agree to exchange goods or services between them.

If you are involved in a barter transaction, the goods or services you receive could be considered proceeds from a business operation.

If you are in a business or profession that provides goods or services, and you exchange these goods or services in a barter transaction, you have to include the value of the goods or services you exchanged in your income.

Barter transactions may also have GST/HST implications. For more information, see Guide RC4022, General Information for GST/HST Registrants.

Selling a property

If you sell a capital property, you may have:

  • a recovery of capital cost allowance, known as recapture
  • an undepreciated balance in a class and no property remaining in that class, known as a terminal loss
  • a capital gain or a capital loss. For example, if you sell a capital property for more than it cost, you have a capital gain, and if you sell it for less than it cost, you have a capital loss

For more information on recaptures and terminal losses, see the Income Tax Folio, S3-F4-C1, General Discussion of Capital Cost Allowance.

For more information on capital gains and capital losses, see Guide T4037, Capital Gains, and for additional rules relating to farmers, see Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

There may be GST/HST implications when you sell a property. For more information, see Guide RC4022, General Information for GST/HST Registrants.

Inventory and cost of goods sold

You need to do an annual inventory. This is usually a list of goods held for sale. If you are a manufacturer, this includes raw materials as well as packaging material and supplies, work-in-progress (goods and services that you have not yet completed at the end of your fiscal period), and finished goods that you have on hand. Inventory is used to calculate the cost of goods sold and net income on Form T2125, Statement of Business or Professional Activities.

If you have a professional practice and you are an accountant, dentist, lawyer, medical doctor, notary, veterinarian, or chiropractor, you can elect to exclude your work-in-progress (WIP) when you determine inventory.

Under proposed changes, if you have a tax year that begins after March 21, 2017, you can no longer elect to exclude amounts for WIP. Transitional rules will phase in the inclusion of WIP into income evenly over 5 years.

However, the new proposed rules allow you to include your WIP progressively if you elected to use billed basis accounting for the last tax year that started before March 22, 2017. Generally, for the first tax year that starts after March 21, 2017, you must include 20% of the lesser of the cost and the fair market value of WIP; the inclusion rate increases to 40% in the second year that starts after March 21, 2017, 60% in the third year, 80% in the fourth year, and finally 100% in the fifth and all subsequent tax years that start after March 21, 2017.

For more information, see Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

How to value your inventory

The value you place on the items in your year-end inventory is important in determining your income.

For income tax purposes, the two acceptable methods of valuing your inventory are by determining either:

  • the fair market value of your entire inventory (use either the price you would pay to replace an item or the amount you would get if you sold an item)
  • the value of individual items (or classes of items, if specific items are not easy to distinguish) in the inventory, at their cost or their fair market value, whichever is lower

Other methods of valuing inventory may be available or required depending on the type of business. For example, property described in the inventory of a business that is an adventure or concern in the nature of trade must be valued at the cost at which the taxpayer acquired the property.

If you have property that is a swap agreement, a forward purchase or sale agreement, a forward rate agreement, a futures agreement, an option agreement, or any similar agreement, different rules may apply to you.

After you choose a method of inventory valuation, you have to continue to use the same method in later years. For more information, see archived Interpretation Bulletin IT-473R, Inventory Valuation.

Expenses

This part of the guide gives you an overview of the business expenses that you can claim for income tax purposes. For more information, go to Businesses or see Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

What are business expenses?

A business expense is a cost you incur for the sole purpose of earning business income.

If you pay cash for any business expenses, be sure to get receipts or other vouchers. Receipts should include the vendor's name and the date.

Running a business from your home

You can deduct expenses for the business use of a work space in your home, as long as you meet one of these conditions:

  • it is your main place of business
  • you use the space only to earn your business income, and to meet your clients or customers

You can deduct part of your maintenance costs, such as heating, home insurance, electricity, and cleaning materials. You can also deduct part of your property taxes, mortgage interest, and capital cost allowance (CCA). To calculate the part you can deduct, use a reasonable basis, such as the area of the work space divided by the total area of your home.

For more information, see Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

Types of operating expenses

Personal or living expenses

In most cases, you cannot deduct personal or living expenses. However, you can deduct travel expenses you incur in the course of carrying on a business while away from home.

The general rule is that you cannot deduct outlays or expenses that are not related to earning business income.

Prepaid expenses

A prepaid expense is an expense you pay ahead of time. If you use the accrual method of accounting, you can claim any expense you have prepaid in the year or years in which you receive the benefit related to that expense.

For more information, see archived Interpretation Bulletin IT-417R2, Prepaid Expenses and Deferred Charges.

Accounting and legal fees

You can deduct fees you incur for external professional advice, services, and consulting fees.

You can deduct accounting and legal fees you incur to get advice and help in keeping your books and records. You can also deduct fees you incur for preparing and filing your income tax and GST/HST returns.

For more information, see archived Interpretation Bulletin IT-99R5-CONSOLID, Legal and Accounting Fees.

Advertising expenses

You can deduct expenses for advertising, which include ads in Canadian newspapers, on Canadian television and radio stations. You can include any amount you paid as a finder's fee.

Certain restrictions apply to the amount of the expense you can deduct for advertising in a periodical. You can deduct all the expense if your advertising is directed to a Canadian market and the original editorial content in the issue is 80% or more of its total non-advertising content.

You can deduct 50% of the expense if your advertising is in a periodical directed to a Canadian market and the original editorial content in the issue is less than 80% of its total non-advertising content.

You cannot deduct expenses for advertising directed mainly to a Canadian market when you advertise with a foreign broadcaster.

Business tax, fees, licences, and dues

You can deduct all annual licence fees and some business taxes you incur to run your business. Some examples of licence fees are: beverage licenses; business charges; trade licences; motor vehicle licenses; and motor vehicle registration permits. Some examples of business taxes that may be deductible are: municipal taxes; land transfer taxes; gross receipt tax; health and education tax; and hospital tax. Income taxes are not deductible.

You can deduct annual dues or fees to keep your membership in a trade or commercial association. However, you cannot deduct club membership dues (including initiation fees), if the main purpose of the club is to provide dining, recreational, or sporting facilities for its members.

Insurance expenses

You can deduct regular commercial insurance premiums that you pay for buildings, machinery, and equipment that you use for your business.

Interest and bank charges

You can deduct the interest you pay on money you borrow to run your business. However, there are some limits.

There is a limit on the interest you can deduct on money you borrow to buy a passenger vehicle. For more information, see "Motor vehicle expenses" in Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

There is also a limit on the amount of interest you can deduct for vacant land.

You can choose to capitalize the interest expense you pay on the money you borrow for any of the following purposes:

  • to buy depreciable property
  • to buy a resource property
  • for exploration and development

For exploration and development, when you choose to capitalize interest, you add the interest to the cost of the property or the exploration and development costs.

Do not deduct the capitalized interest as a current expense. For more information, read "Line 8710 – Interest and bank charges" in Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income. For more information on deducting interest, see Income Tax Folio S3-F6-C1, Interest Deductibility.

Maintenance and repairs

You can deduct the cost of labour and materials for any minor repairs or maintenance done to property you use to earn income. However, you cannot deduct the value of your own labour.

You cannot deduct costs you incur for capital repairs. However, you may be able to claim capital cost allowance on repaired property.

For more information about capital cost allowance, see Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

Meals and entertainment

The maximum part you can claim for food, beverages, and entertainment expenses is 50% of either the amount you incur or an amount that is reasonable in the circumstances, whichever is less.

The 50% limit also applies to the cost of your meals when you travel or go to a convention, conference, or similar event. Special rules can, however, affect your claim for meals in these cases. For more information, see "Meals and entertainment," "Convention expenses," or "Travel," in Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

For more information, see archived Interpretation Bulletin IT-518R, Food, Beverages, and Entertainment Expenses.

Motor vehicle expenses

You can deduct expenses you incur to run a motor vehicle that you use to earn business income. However, several factors can affect your deduction.

What kind of vehicle do you own?

The kind of vehicle you own can affect the expenses you deduct. For income tax purposes, there are two types of vehicles:

For more information about capital cost allowance limits, interest limits, and leasing costs, see Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

You can deduct motor vehicle expenses only when they are reasonable and you have receipts to support them.

The types of expenses you can deduct include:

  • fuel and oil
  • maintenance and repairs
  • insurance
  • licence and registration fees
  • capital cost allowance
  • interest you pay on a loan used to buy a motor vehicle
  • leasing costs

For more information about motor vehicles, see Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

Office expenses

You can deduct office expenses for small items such as pens, pencils, paper clips, stationery, and stamps. Expenses for capital items such as calculators, filing cabinets, chairs, and desks are claimed differently. For more information, see capital cost allowance in the Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income.

Salaries, including employer's contributions

You can deduct the cost of salaries you pay to employees. You report each salary by the end of February on a T4, Statement of Remuneration Paid, or T4A, Statement of Pension, Retirement, Annuity and Other Income. For more information on these slips, see Guide T4001, Employers' Guide – Payroll Deductions and Remittances.

Can you deduct business start-up costs?

To deduct a business expense, you need to have carried on the related business in the fiscal period in which the expense was incurred. You need to be clear about the date your business started.

To determine what you can claim as a start-up expense, see archived Interpretation Bulletin IT-364, Commencement of Business Operations, or Guide RC4022, General Information for GST/HST Registrants.

How to report your business income

Sole proprietor

A sole proprietor pays taxes by reporting income (or loss) on a T1 income tax and benefit return.

If you are a sole proprietor, you or your authorized representative have to file a T1 return if you:

You also need to file a return if you are claiming an income tax refund, a refundable tax credit, a GST/HST credit, or the Canada Child Benefit. You should also file a return if you are entitled to receive provincial tax credits.

The list above does not include every situation where you might have to file.

Note

As a sole proprietor, you may have to pay your income tax by payments called instalments. You may also need to make instalment payments for CPP contributions on your own income. For more information, go to Paying your income tax by instalments.

When you file your income tax and benefit return, you must include financial statements or one or more of the forms that applies to your business income listed previously at "Income – How to account for your business income."

Partnership

A partnership by itself does not pay income tax on its operating results and does not file an annual income tax return. Instead, each partner includes a share of the partnership income (or loss) on a personal, corporate, or trust income tax return.

Each partner has to file financial statements or one of the forms referred to above that outlines the statement of business activities.

A partnership that carries on a business in Canada, or a Canadian partnership with Canadian or foreign operations or investments, has to file Form T5013, Statement of Partnership Income, for each of the fiscal periods of the partnership where, one of the following occurs:

  • at the end of the fiscal period, the partnership has an absolute value of revenues plus an absolute value of expenses of more than $2 million, or has more than $5 million in assets
  • at any time during the fiscal period:
    • the partnership is a tiered partnership (has another partnership as a partner or is itself a partner in another partnership)
    • the partnership has a corporation or a trust as a partner
    • the partnership invested in flow-through shares of a principal-business corporation that incurred Canadian resource expenses and renounced those expenses to the partnership
    • the Minister of National Revenue asked in writing for a completed Form T5013, Statement of Partnership Income

For more information, see Guide T4068, Guide for the Partnership Information Return (T5013 Forms).

Corporation

A corporation has to file a T2 corporation income tax return no later than six months after the end of every tax year, even if it does not owe taxes. It also has to attach complete financial statements and the necessary schedules to the return.

A corporation usually pays its taxes in monthly or quarterly instalments. For more information on instalment payments and the filing requirements for corporations, see Guide T4012, T2 Corporation – Income Tax Guide, or Guide T7B CORP, Corporation Instalment Guide, or go to Make a payment to the Canada Revenue Agency.

The tax year for a corporation is its fiscal period. For more information on corporations, go to Corporation.

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