Income Tax Audit Manual
Compliance Programs Branch (CPB)
This chapter was last updated November 2021
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Chapter 27.0 Income
Table of Contents
- 27.1.0 Capital gain or business income?
- 27.2.0 Pursuit of profit
- 27.3.0 Damage payments
- 27.4.0 Employee and shareholder benefits
- 27.5.0 Employed vs self-employed
- 27.6.0 Farming and fishing income
- 27.7.0 Foreign currency exchange
- 27.8.0 Lawyers' disbursements
- 27.9.0 Inducement payments
- 27.9.1 Introduction
- 27.9.2 Overview of income tax legislation relating to inducement payments
- 27.9.3 Depreciable property
- 27.9.4 Capital property other than depreciable property
- 27.9.5 Elective provisions
- 27.9.6 Example of the application of paragraph 12(1)(x)
- 27.9.7 Deductibility of inducement payments
- 27.9.8 Court decisions
- 27.9.9 References
- 27.10.0 Income of professionals and fiscal period issues
- 27.11.0 Social assistance payments
- 27.12.0 Unreasonable amounts
In Friesen v The Queen, 95 DTC 5551, Justice Major provided an overview of the scheme of the Income Tax Act (ITA). He stated that:
"Section 3 of the Income Tax Act sets out the ground rules for the computation of a taxpayer's income for a taxation year. Section 3 recognizes two basic categories of income: "ordinary income" from office, employment, business and property, all of which are included in subsection 3(a), and income from a capital source, or capital gains which are covered by subsection 3(b). The whole structure of the Income Tax Act reflects the basic distinction recognized in the Canadian tax system between income and capital gain.
Subdivision b of Division B of the Act entitled "Income or Loss from a Business or Property" contains all the rules which govern business and property income. The leading section in this subdivision is section 9 of the Act, which provides that a taxpayer is taxable on the profit for a business or property for the year. Profit is not defined in the Income Tax Act.
Unlike business or property income which is fully taxable, income from capital sources was not subject to tax at all in Canada until 1972 and is still partially protected from taxation. Subdivision c of Division B of the Act entitled "Taxable Capital Gains and Allowable Capital Losses" contains all of the rules, which apply to income derived from a capital source. The leading section in this subdivision is section 38 which provides that a taxpayer is taxable on 3/4 (the inclusion rate is currently 50%) of the capital gain from the disposition of property in the year".
Justice Major also stated that:
"The Income Tax Act has established a system with two distinct categories of property -- inventory, which creates business income or loss, and capital property, which creates capital gain or loss. There are separate rules for each of these two categories of property and the taxpayer should be entitled to take the benefit as well as bear the burden applicable to the category into which the property falls."
The terms capital gain and capital loss are defined in section 39 of the ITA. These definitions assume that the property disposed of is a capital property. It is a question of fact whether or not a property is acquired and used on account of income or capital. The factors outlined in 27.1.2 must be considered in order to determine whether a gain or loss on the disposition of property is on account of income or capital.
It is advantageous for a taxpayer to report gains from the disposition of property as capital gains, as only a portion of a capital gain is taxable (the current inclusion rate is 50%), while profit arising from a business is fully taxable. As well, certain types of property are eligible for the capital gains exemption under section 110.6 of the ITA. Conversely, a loss is more advantageous if it is reported as a business loss because it is fully deductible and not subject to the capital loss restrictions. The Taxpayer Bill of Rights states that taxpayers have the right to receive entitlements and to pay no more and no less than what is required by law.
The taxpayer and the CRA will often have a difference of opinion whether a transaction is of an income or capital nature. Taxpayers have the right to have the law applied consistently and they also have the right to lodge a service complaint and request a formal review without fear of reprisal according to the Taxpayer Bill of Rights. For more information, go to Taxpayer Bill of Rights.
The distinction between business income and capital gains is whether the taxpayer is trading or investing in property. An investment is an asset acquired with the intention of holding or using it to produce income. If property is acquired with an intention to trade, that is to purchase and resell the property at a profit, any gain or loss is characterized as business income (loss). The taxpayer's intention when acquiring property is a major factor in determining how a gain or loss should be treated when the property is sold.
In order to determine if a gain is on account of income or capital, the auditor must review the circumstances of the transaction and consider a number of factors established by the courts. The courts have considered factors such as the following:
- taxpayer's intention
- nature of the property
- number and frequency of transactions
- method of and reason for the disposition
- relationship between the transaction and the taxpayer's ordinary business, including the taxpayer's knowledge
- declared objects of the corporation for transactions by a corporation
None of the factors above is conclusive in itself for the purpose of determining that a gain arising on the sale of property constitutes income or a capital gain. The relevance of any factor to such a determination will vary with the facts of each case.
The auditor must fill in a Capital Gain vs Income Report (go to 11.6.3), summarizing the facts, and including the:
- description of the property
- period of ownership
- history of similar transactions
- circumstances surrounding the sale of the property
- improvements made to the property
- reason the property was acquired
In most instances, the taxpayer will want to consider a gain as a capital gain and a loss as a business loss. The auditor's task is to obtain sufficient information and documentation to objectively determine the taxpayer's intent in acquiring the property and if the subsequent gain or loss on disposition is on account of capital or income.
Once a decision is made that a transaction needs to be reviewed in-depth, the auditor should carry out the following review:
- verify the calculation of the income or capital gain as reported by the taxpayer
- obtain the facts: by reviewing relevant documentation, interviewing the taxpayer and others as necessary, and obtaining information from third parties (for example, land registry office and municipal planning department), as required
- review the relevant jurisprudence
- reach a preliminary conclusion and discuss the findings with the taxpayer
- after fully considering the taxpayer's representations, make a decision and prepare a Capital Gain vs Income Report
A gain arising on the sale of real estate is considered to be business income, property income, or a capital gain. The term business is defined in subsection 248(1) of the ITA, so as to include an adventure or concern in the nature of trade. This definition can cause an isolated transaction involving real estate, where the taxpayer expends little or no time or effort, to be considered a business transaction. Consequently, the auditor must examine all the facts to ascertain the taxpayer's course of conduct and intention in dealing with the real estate, as the taxpayer's stated intention on its own is not sufficient.
To determine if gains from the sale of real estate are income or capital, the courts have considered factors, such as those listed below (the list is not intended to be exclusive of any other factor):
- taxpayer's intention with respect to the real estate at the time of its purchase
- feasibility of the taxpayer's intention
- geographical location and zoned use of the real estate acquired
- extent to which intention carried out by the taxpayer
- audit evidence that the taxpayer's intention changed after purchase of the real estate
- nature of the business, profession, calling, or trade of the taxpayer and associates
- extent to which borrowed money was used to finance the real estate acquisition and the terms of the financing, if any, arranged
- length of time the real estate was held by the taxpayer
- existence of persons other than the taxpayer who share interests in the real estate
- nature of the occupation of the other persons referred to above, as well as their stated intentions and courses of conduct
- factors which motivated the sale of the real estate
- audit evidence that the taxpayer or associates or both had dealt extensively in real estate
None of the factors listed above is conclusive in itself for the purposes of determining that a gain arising on the sale of real estate constitutes income or a capital gain. The relevance of any factor to such a determination will vary with the facts of each case.
A taxpayer's intention at the time of purchase of real estate is relevant in determining if a gain will be treated as business income or as a capital gain when the property is sold. At the time of acquiring real estate, it is possible for a taxpayer to have the alternate or secondary intention of reselling it at a profit, if the main or primary intention is thwarted. If this secondary intention is carried out, any gain realized on the sale usually will be taxed as business income.
For more information about gains arising on the sale of real estate, go to Income Tax Interpretation Bulletin IT218R, Profits, capital gains and losses from the sale of real estate, including farmland and inherited land and conversion of real estate from capital property to inventory and vice versa.
Documents relating to real estate transactions
When auditing for transactions involving the disposition of real estate, the auditor should obtain and review the following documentation:
- Provisional agreement, offer to purchase, contract of purchase, and deed of sale
• may show the mortgages on the property and the financial arrangements that the seller is willing to grant to sell the property
• may show a multiple listing number indicating how long the property was on the market
• indicates the date of acquisition, the total cost of the property, the amount of the deposit, the balance owing, as well as the names, addresses and marital status of the vendors and purchasers
- Statement of adjustments
• the vendor's notary or lawyer usually prepares this document
• indicates the name of the owner or owners, the dates of purchase and sale, the total value of the transaction, the mortgages granted or assumed, the adjustments for property taxes, interest, heating oil, etc., and the down payment
• indicates the commissions paid and the name of the recipients
• makes it easier to calculate the gain or loss resulting from the disposition
• may provide certain information on the specified use of the property
- Mortgage contract
• indicates the total amount of the mortgage, the interest rate, the term, and the terms and conditions of payment, as well as the mortgage lender
• helps to determine if the taxpayer has sufficient capital to hold the real estate as an investment
• makes it easier to calculate the adjusted cost base and the outlays associated with the disposition
• may provide details on other property owned by the taxpayer and used as collateral to obtain the financing
• if the vendor used a valuation day value to calculate the gain, an appraisal may have been prepared, which the auditor should review
• if another valuation method was used, the auditor must obtain the details
- Subdivision plans
• when a large property is subdivided into smaller lots, the taxpayer must submit a subdivision plan to the municipality, which includes a legal description of the property and information regarding its intended use
• this document is submitted in the form of a lot plan
- Zoning application
• applications for changes to zoning regulations must be submitted in writing
• a verbal request or a conversation between a taxpayer and a municipal official do not constitute an official zoning application
- Listing agreements
• a copy of the real estate agency's listing agreement provides a description of the property and the length of time it was on the market
• may give information on zoning
A gain or loss from the disposition of shares or a debt obligation, such as a bond, debenture, or note, will be taxed as either an income gain or loss, or as a capital gain or loss. Some security transactions are clearly on income account. These include transactions for:
- underwriting and promotion activities
- a taxpayer who holds them self out to the public as a dealer in securities
- a corporation whose prime activity is trading in securities, even if it does not hold itself out to the public as a trader or dealer in securities
- a taxpayer who was a money lender or a trader or dealer in debt obligations
- a taxpayer who uses information that is not publicly available to realize a quick profit
- a short sale of shares
- a disposition of shares used as an alternative method to realize income from the sale of property held by a corporation, such as real estate
Election regarding the disposition of Canadian securities
If a taxpayer has disposed of a Canadian security in a tax year, subsection 39(4) of the ITA provides that the taxpayer may elect in the return of income for that year that:
- every Canadian security owned by the taxpayer in that year or any subsequent year is deemed to be capital property owned in those years, and
- every disposition of every Canadian security owned by the taxpayer in that and any subsequent year is deemed to be a disposition of a capital property.
The effect of such an election is that all Canadian security dispositions in the year of election and all subsequent years, must be given capital gain or loss treatment and the election cannot be rescinded.
Pursuant to subsection 39(5), the election under subsection 39(4) does not apply to a disposition of a Canadian security by a taxpayer who, at the time the security is disposed of, is:
- a trader or dealer in securities
- a financial institution (as defined in subsection 142.2(1))
- a corporation whose principal business is the lending of money or the purchasing of debt obligations or a combination thereof, or
- a non-resident, or
- any combination thereof
An election that has been made under subsection 39(4) does not apply to any securities disposed of during the time that subsection 39(5) applies to a taxpayer. During the time the election does not apply, examine the facts of the specific transaction to determine whether the disposition is on income or capital account.
Disposition of securities - Income or capital
In all cases, auditors have to examine the facts of the specific case and consider the factors the courts have applied in determining if a transaction is on income or capital account. The tests that the courts have applied in making such a determination are those of course of conduct and intention.
If the whole course of conduct indicates that in security transactions, the taxpayer is disposing of securities in a way capable of producing gains and with that object in view, and the transactions are of the same kind and carried on in the same way as those of a trader or dealer in securities, the proceeds of sale will normally be considered to be income from a business and, therefore, on income account.
Some of the factors to be considered in determining whether the taxpayer's course of conduct indicates the carrying on of a business, are as follows:
- frequency of transactions - a history of extensive buying and selling of securities or of a quick turnover of properties
- period of ownership - securities are usually owned only for a short period of time
- knowledge of securities markets - the taxpayer has some knowledge of or experience in the securities markets
- security transactions form a part of a taxpayer's ordinary business
- time spent - a substantial part of the taxpayer's time is spent studying the securities markets and analyzing potential purchases
- financing - security purchases are financed primarily on margin or by some other form of debt
- advertising - the taxpayer has advertised or otherwise made it known that they are willing to purchase securities
- in the case of the shares, their nature - normally speculative in nature or of a non-dividend type
Although none of the individual factors above may be sufficient to characterize the activities of a taxpayer as a business, the combination of a number of those factors may well be sufficient for that purpose. As well, subsection 248(1) defines business to include an adventure or concern in the nature of trade (go to 27.1.6), and the courts have held that the term "an adventure or concern in the nature of trade" can include an isolated transaction in shares where the course of conduct and intention clearly indicate it to be such.
For more information about the characterization of a disposition of securities, including share options, go to Income Tax Interpretation Bulletin IT479R, Transactions in securities.
Documents relating to securities transactions
When auditing for transactions involving the disposition of securities, the auditor should obtain and review the following documentation:
1) Statements of purchase and sale, which indicate:
- sales proceeds, acquisition costs and expenses, which are needed to calculate the gain or loss
- number of transactions during a given period
- period the investments were held
2) A copy of the financing documents, if borrowed funds were used to acquire the securities
These documents will provide information regarding:
- financing expenses incurred with respect to the securities
- amount of personal funds invested (if the investment involves a high proportion of personal funds, it is probable that the transaction will be treated as capital)
3) Any other documentation and information that will assist in establishing the:
- taxpayer's knowledge of the securities market
- relationship between the securities transactions and the taxpayer's ordinary business
- time devoted to investment activities
- steps taken by the taxpayer to make them self known as a buyer of securities
- taxpayer's intentions
If a taxpayer consistently carries on an activity that is capable of producing a profit, then the taxpayer is carrying on a trade or business, even though the activity may be separate from the taxpayer's ordinary occupation. If such an activity is done infrequently, or only once, it is still possible to conclude that the taxpayer is engaged in a business transaction, if it can be shown that there was an adventure or concern in the nature of trade. An adventure or concern in the nature of trade is included in the definition of business in subsection 248(1) of the ITA.
A taxpayer who engaged in a transaction that is considered an adventure or concern in the nature of trade is not necessarily considered to be carrying on a business or to have carried on a business. An isolated transaction could be considered an adventure in the nature of trade, while a series of transactions could constitute a situation that the taxpayer is carrying or has carried on a business.
Paragraph 4 of Income Tax Interpretation Bulletin IT459, Adventure or Concern in the Nature of Trade, states the following:
"In determining whether a particular transaction is an adventure or concern in the nature of trade the Courts have emphasized that all the circumstances of the transaction must be considered and that no single criterion can be formulated. Generally, however, the principal tests that have been applied are as follows:
(a) whether the taxpayer dealt with the property acquired by him in the same way as a dealer in such property ordinarily would deal with it
(b) whether the nature and quantity of the property excludes the possibility that its sale was the realization of an investment or was otherwise of a capital nature, or that it could have disposed of other than in a transaction of a trading nature
(c) whether the taxpayer's intention, as established or deduced, is consistent with other evidence pointing to a trading motivation"
The following factors, in and of themselves, are not sufficient to prevent a finding that a transaction was an adventure or concern in the nature of trade:
- the transaction was a single or isolated one
- the taxpayer did not create any organization to carry-out the transaction
- the transaction is totally different from any of the taxpayer's other activities and they never entered into such a transaction either before or since
To improve the quality of reassessments, note that individual factors, such as property held for only a short time, which may support a finding that a gain be treated as income rather than a capital gain, is not conclusive support by itself and must be viewed with all the facts of the case. The courts have also held that a secondary intention to sell a property for a profit is almost invariably present even when a true investment is acquired. As a result, the argument that a taxpayer has a secondary intention to sell a property for a profit should not be used, unless there is corroborating audit evidence to support a position that the profit in question is income from an adventure or concern in the nature of trade.
If the characterization of a gain is considered during an audit, prepare a Capital Gain vs Income Report and inform the taxpayer in writing of the proposed reassessment. Set out the reasons in support of the proposal in the letter and request that the taxpayer reply and provide arguments if they disagree.
The Capital Gain vs Income Report is essential, and provides a complete summary of the facts and contains a recommendation for the position adopted with supporting reasons. The report should inform the reader of the situation without the need to refer to other working papers or files. For instructions on how to prepare this report, go to 11.6.3, Capital Gain vs Income Report.
The Capital Gain vs Income Report, auditor's working papers, and other supporting documentation must be in sufficient detail to make sure that if an objection or appeal is filed, the auditor will be able to recall and identify documents and offer testimony regarding the facts of the case.
Adequate supporting audit evidence is essential, as the burden of proof shifts to the CRA as soon as the taxpayer provides a plausible explanation for their actions. Unless it is clear from the facts of the case that a transaction is an adventure or concern in the nature of trade, the taxpayer's stated intention must not be arbitrarily disregarded. Therefore, the CRA must provide audit evidence to refute the taxpayer's stated intention or establish that their whole course of conduct indicates an adventure or concern in the nature of trade.
Value of property for inventory purposes
Under subsection 10(1.01) of the ITA, property described in an inventory of a business that is an adventure or concern in the nature of trade must be valued at its cost of acquisition to the taxpayer.
Subsection 10(1.01) was enacted in response to the decision of the Supreme Court of Canada in Friesen v The Queen, 95 DTC 5551, in which it was held that the rules applying to the valuation of business inventory for the purposes of computing income from business also apply to property held as an adventure in the nature of trade with the result that losses arising from this type of property could be recognized before the year of disposition. As a result of subsection 10(1.01), losses arising from property held as an adventure in the nature of trade can only be recognized upon the disposition of the property.
Income Tax Interpretation Bulletins
- IT218R, Profits, capital gains and losses from the sale of real estate, including farmland and inherited land and conversion of real estate from capital property to inventory and vice versa
- IT346R, Commodity Futures and Certain Commodities
- IT426R, Shares Sold Subject to an Earnout Agreement
- IT459, Adventure or Concern in the Nature of Trade
- IT473R, Inventory Valuation
- IT479RSR, Transactions in Securities
- IT479R, Transactions in securities
Real estate transactions
Adventure in the nature of trade
Friesen v The Queen 95 DTC 5551 [SCC]
154135 Canada Inc v The Queen 2000 DTC 1708
White et al v The Queen 97 DTC 435
Miller v The Queen 95 DTC 542
Happy Valley Farms Ltd v The Queen 86 DTC 6421 [FCTD]
Pellerin et al v MNR 91 DTC 107
Litvinchuk v The Queen 96 DTC 1315
Marsted Holdings Ltd et al v The Queen 86 DTC 6200
Lampard v MNR 86 DTC 1422
Intention abandoned - Frustrated
Arya v The Queen 94 DTC 1526
Jodare Ltd et al v The Queen 86 DTC 6054
Bell et al v MNR 89 DTC 165
Change of intention
Araz Developments Inc et al v The Queen 93 DTC 922
600166 Ontario Ltd et al v MNR 93 DTC 910
Mohawk Horning Ltd et al v The Queen 86 DTC 6297
Zen v The Queen 85 DTC 5531
Malysh v MNR 90 DTC 1803
Ough v MNR 87 DTC 581
Orzeck v MNR 87 DTC 618
Buyer specializing in real estate
Lal et al v The Queen 98 DTC 1155
Shindico Inc v The Queen 94 DTC 1538
Immeubles Jos Pelletier Inc v The Queen 93 DTC 1552
Anctil v The Queen 93 DTC 1525
Niemi v The Queen 84 DTC 6189
Tsao et al v MNR 82 DTC 1821
Period of ownership
Mullin v The Queen 98 DTC 1731
Watson v The Queen 98 DTC 1680
Singh v The Queen 97 DTC 5064
Tordale Developments Ltd v The Queen 97 DTC 1442
Belley c La Reine 97 DTC 1430
Buffone v The Queen 93 DTC 1486
Dauphinais v MNR 93 DTC 631
Carsons Camps Ltd v The Queen 84 DTC 6070
Haber v The Queen 83 DTC 5004
Purpose of the purchase
Bahr et al v The Queen 96 DTC 1576
Fisher et al v The Queen 96 DTC 1391
Conway v The Queen 96 DTC 1282
364256 Ontario Ltd et al v MNR 93 DTC 787
Campeau v MNR 93 DTC 92
Division into lots
Kourdi et al v The Queen 99 DTC 5428
Friesen v The Queen 95 DTC 5551
Deacon v The Queen 95 DTC 793
Morris et al. v The Queen 93 DTC 1186
Choinière et al v The Queen 97 DTC 91
Series of transactions
Matt's Apartments Ltd v MNR 89 DTC 441
Happy Valley Farms Ltd v The Queen 86 DTC 6421
Toolsie v The Queen 86 DTC 6117
Other business activities
Medici Management Ltd v MNR 89 DTC 437
Decisive activities regardless of recession
Deshaies Inc v MNR 93 DTC 867
Property used for farming
Roseland Farms Ltd v MNR 86 DTC 1086
Leaside Realty Co v MNR 86 DTC 1020
Farrell et al v MNR 85 DTC 706
Finley v MNR 84 DTC 1536
Relationship with the real estate agent
Abed Estate v The Queen 82 DTC 6099
Boychuk v MNR 81 DTC 107
Dyck v MNR 81 DTC 54
Vacant lots or land
Unsolicited offer to purchase
Di Ioia et al v The Queen 94 DTC 1331
Thivy v The Queen 93 DTC 919
Intention to invest
H Fine and Sons Ltd v The Queen 84 DTC 6520
Transactions involving securities
Options and shares
Forest Lane Holdings Ltd et al v The Queen 90 DTC 6495
Algonquin Enterprises Ltd et al v The Queen 90 DTC 6377
Sullivan v The Queen 90 DTC 6191
Watts Estate et al v The Queen 84 DTC 6564
Darch et al v The Queen 92 DTC 6366
Transactions involving horses
Imperial Stables (1981) Ltd v The Queen 92 DTC 6189
The Queen v Friedberg 93 DTC 5507
Côté v The Queen 96 DTC 3304
Meaning of traders or brokers in securities
The Queen v Vancouver Art Metal Works Ltd. 93 DTC 5116
Kane (CC) v The Queen 94 DTC 6671
Robertson v The Queen 98 DTC 6227
Zoning and restriction of land use
Expansion of business
Bakos et al v MNR 84 DTC 1509
Gain on foreign exchange
Shell Canada Ltd v the Queen 99 DTC 5669 [SCC]
In 1977, the Supreme Court ruled on the case of Moldowan v The Queen, 77 DTC 5213. In his reasons, Justice Dickson addressed the issue of what would be considered a reasonable expectation of profit (REOP). In a non-exhaustive list, he included an objective look at: “the profit and loss experience in past years, the taxpayer's training, the taxpayer's intended course of action, the capability of the venture as capitalized to show a profit after charging capital cost allowance.” Considering: the scheme of the Income Tax Act (ITA), the common definition of “business,” the definition of “personal or living expenses” in subsection 248(1), and the intent of paragraphs 18(1)(a) and (h), CRA viewed that if there was no REOP, then there was no source for the purposes of section 3 and, therefore, losses could not be deducted.
In 2002, the Supreme Court ruled on the case Stewart v The Queen, DTC 6969. In their reasons, Justices Iacobucci and Bastarache discussed a number of lower court cases that viewed the REOP issue differently. It was their finding that REOP alone is not a relevant means of determining whether an activity constitutes a source of income. An activity undertaken in the pursuit of profit, even with erroneous business decisions that cause it to never experience any actual profit, is still a source of income. They deemed that if an activity included no personal element, then it was a source of income. If there was a personal element, it may still be a source of income if the activity was undertaken in a “sufficiently commercial manner.”
In order for an activity to be classified as being done in a “sufficiently commercial manner,” the taxpayer must have the subjective intention to profit and, as stated in Moldowan, this determination should be made by looking at a variety of objective factors. It requires the taxpayer to establish that their predominant intention is to make a profit from the activity and that the activity has been carried out in accordance with objective standards of businesslike behaviour.
In order to determine if there is a source of income, auditors should proceed with a two-stage approach (taken from Stewart v The Queen, paragraph 50):
- Is the activity of the taxpayer undertaken in pursuit of profit, or is it a personal endeavour?
- If it is not a personal endeavour, is the source of the income a business or property?
The first stage of the test assesses the general question of whether or not a source of income exists; the second stage categorizes the source as either business or property.
The Pursuit of Profit Report must be used to support that an activity does not constitute a source of income. The report is available in the Integras Template Library, listed as A-11_2_22 Pursuit of Profit Report. The report is also available in the CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms.
The courts have not explicitly defined the term “personal element,” but the Supreme Court in Stewart (at paragraph 5) states that “where there is a suspicion that the taxpayer's activity is a hobby or personal endeavour rather than a business, the taxpayer's so-called reasonable expectation of profit is a factor, among others, which can be examined to ascertain whether the taxpayer has a commercial intent.”
A personal endeavour or endeavour with a personal element means that the person undertakes the activity, at least in part, for personal satisfaction regardless of other factors, such as profit. This is not the same as enjoying one’s profession and should not be confused with a business with personal portions. For example, a restaurant owner who takes meals at work, or a taxi driver who uses the cab for personal events on the weekend. The reason for the activity is not these personal aspects.
Some factors to consider:
- Length of time with activity: was it a hobby that turned into a business, did the taxpayer learn the business as a child?
- Customer base: if most of the customer base are relatives or neighbours, it may be a sign of a personal element: Mary Kay; Tupperware; Avon; interior design, etc.
- Manner in which business was conducted: the “professional” bass tournament fisher who only attends four local tournaments a year; no scheduled hours, part time; lack of business plan / direction. Although this is similar to second-stage questions on commerciality and pursuit of profit, the intent here is to indicate if the activity was undertaken in a manner similar to other personal pursuits.
- Price structure: if price is below fair market value, is that because of a personal element, such as renting out a basement apartment?
- Place of business: several court cases indicate, notably Pakzad v The Queen, 2016 DTC 1135 at paragraph 46, that use of the personal residence “imports a personal element.”
If there is no personal element identified, then the activity is a source of income and paragraphs 18(1)(a) and (h) and section 67 should be relied upon to remove any personal portions from revenues and expenses.
If there is a personal element, the next section will help determine if the activity is undertaken in a sufficiently commercial manner, or whether it should not be considered a source of income.
Operating in a sufficiently commercial manner is synonymous with operating with a reasonable expectation of profit or in a pursuit of profit. This review is only undertaken if there has been a personal element identified. However, the fact that a personal element exists does not indicate that the activity is not a source of income. Judge Bowman states in Martin v The Queen, 2003 TCC 155 at paragraph 18:
The existence of a personal element must be put in perspective. There is frequently a personal element in the carrying on of a commercial enterprise in the sense that the person derives great personal satisfaction from the activity. This does not make the activity any the less a business. Professional artists, photographers, writers, musicians (and sometimes even lawyers) no doubt derive great satisfaction from what they do but if their activity is commercial and is intended to yield a profit it is nonetheless a business. It is only where the personal element so overshadows any element of commerciality as to substantially displace it that one may conclude that the activity is merely a hobby and is not a business at all.
Four central factors evaluated to determine commerciality were outlined in Moldowan. However, subsequent to Moldowan, the courts have reviewed a growing number of factors or “indicia of trade” to lend weight to evaluation. No one factor is paramount, and the weight placed on each is dependent on the circumstances.
Some factors to consider:
- Intent: whatever concrete audit evidence exists that a taxpayer has intended to pursue profit. A few posts to a website like Kijiji or a classified ad in one newspaper may not substantiate intent, but, in conjunction with several other factors, may provide enough audit evidence. We should not assess a taxpayer’s business acumen, but rather their intention.
- Revenues: are they static, have they grown, how has the taxpayer reacted to changes, is there any indication that the taxpayer is seeking to grow revenues, does the taxpayer change sales prices when the cost of expenses changes, how is a sales price determined?
- Expenses: disregarding those that would clearly be disallowed under paragraphs 18(1)(a) and (h), do the revenues support the expense level? Is there a close connection between the expense and a business reason (buying a $250,000 thirty-foot yacht because you sell three waterfront properties a year might not be valid)? Is there an effort to restrain expenses – checking with alternate suppliers, etc?
- Growth of business: is the taxpayer trying to grow the business; trying to obtain more of the market, trying to widen the market (other geographic areas or target audiences)? Is the taxpayer’s capacity expanding or shrinking? Is there audit evidence of advertising or planning to support the conclusion?
- Nature and extent of losses: are the losses the result of a string of bad luck, odd occurrences, or bad business choices (if so, this is not related to profitability or commercial manner)? Losses are considered exclusive of expenses that would be disallowed under paragraphs 18(1)(a), (h), or section 67.
- Training / education / experience: the more training, knowledge, education, or experience the taxpayer has with the activity, the more likely that the activity can be approached in a commercial manner.
- Financing: borrowing money is typically a sign that a business is attempting to grow and diversify risk.
- Organizational structure / employees: whether a sole proprietorship, partnership, or corporation, if the structure of the business indicates that the taxpayer is trying to obtain skills or assets by bringing in others, this may be a mark of commerciality.
- Capitalization: does the business have the necessary capital infrastructure? Are the revenues able to support the normal depreciation (or capital cost allowance) of the capital assets?
If there is a personal element to the activity and the activity is undertaken in a sufficiently commercial manner, there is a source of income and income must be reported and losses may be claimed.
The ITA makes a distinction, in several sections, of whether the income generated is from a business or property. For example, attribution rules, small business deduction, capital cost allowance, Part XIII tax, and business use of home.
Most businesses require the use of capital assets in order to generate income. Generally, the attention, labour, and time devoted to an activity defines whether it is income from a business.
Income Tax Interpretation Bulletin IT434R, Rental of Real Property by Individual, discusses the nature and extent of services necessary for income from real property (land and building) to be accepted as income from a business as opposed to property.
- Moldowan v The Queen, 77 DTC 5213
- Stewart v The Queen, 2002 DTC 6969
- Fil v The Queen, 2017 DTC 1076
- Pakzad v The Queen, 2016 DTC 1135
- Leith v The Queen, 2016 DTC 1002
- Berger v The Queen, 2015 DTC 1152
- Michaud v The Queen, 2014 DTC 1089
- Bouchard v The Queen, 2013 DTC 1203
- Longo v The Queen, 2013 DTC 1179
- Palangio v The Queen, 2013 DTC 1026
- Bui v The Queen, 2014 DTC 1017
- Syed v The Queen, 2014 DTC 1034
- Sumner v The Queen, 2011 DTC 1335
- Income Tax Interpretation Bulletin IT434R, Rental of Real Property by Individual
- Learning product TD1001-000-PR, Losses: Tax Concepts, Current Year Losses and Losses Carried Over, Pre-reading
There are many situations in both commercial and non-commercial activities where one person causes another person to suffer damages and pays or forfeits an amount of money to that person as compensation. Damages may result from an unlawful act, cancellation of a contract, and acts of omission or negligence. Damages to a person may include pain, suffering, loss of reputation, disadvantage, or inconvenience. The application of the ITA to these payments may be difficult, as they often do not have the characteristics typical of normal business transactions.
This section outlines the application of the ITA to damage payments, other than claims paid by insurance companies. For the purposes of this discussion, damage payments include amounts paid or forfeited in arm's length situations without regard to whether:
- the payment was ordered by the courts or paid according to a private agreement
- there is an admission of wrongdoing
- the damages allegedly suffered have been proven
- the payment is an accurate measure of the actual losses suffered
Damage payments may arise in many different types of situations encompassing both commercial and non-commercial activities. The income tax consequences of damage payments are fairly straightforward when the payments relate to common business practices. For example, moving companies are often required to compensate their customers for goods damaged in transit. These payments are incidental to the usual conduct of business operations and are deductible as current expenses.
However, to determine the income tax implications of damage payments relating to unusual or infrequent transactions or both, thoroughly analyze the facts in each case. The auditor must determine the substance of each payment and the nature of the property for which the compensation is paid. In reviewing the tax implications of certain damage receipts, the courts have stated that it is essential to determine what the compensation is intended to replace. Damages will be treated as ordinary income if the damages represent compensation for the loss of income from business, property, or employment.
Damage payments may have different tax implications for the payer and the recipient. For example, the payer is entitled to deduct the payment as a current expense, while the payment is treated as a capital receipt in the hands of the recipient.
Tax consequences of damage receipts
The CRA's position on the tax treatment of damage receipts is discussed in Income Tax Interpretation Bulletin IT365R2, Damages, settlements, and similar receipts.
The bulletin discusses amounts received:
- as compensation for the loss of property or income
- on termination of employment
- out of claims for damages for personal injury or death
- as crime compensation awards
Note: The policy in paragraph 9 of IT365R2 is being reviewed because of the adverse decision in Ipsco Inc. v The Queen, (TCC) 2002 DTC 1421.
In this case, the taxpayer received compensation from a third party since the system it purchased did not perform to specifications. The TCC treated the receipt as a non-taxable windfall.
Tax consequences of damage payments
The CRA's position regarding the deductibility of damage payments is contained in Income Tax Interpretation Bulletin IT467R2, Damages, Settlements, and Similar Payments.
This bulletin discusses the income tax treatment of amounts paid by a taxpayer as damages in respect of a financial loss or injury caused by a taxpayer to another person, or to a business, or property of another person. The comments in Income Tax Interpretation Bulletin IT467R2 also apply to payments made to mutually end a present or future obligation. As indicated in the bulletin, the income tax treatment of damages, settlements, or similar payments can only be determined in a specific case after an examination of all the relevant facts.
Damage payments must meet the following tests to be deductible as current expenses in computing income; the outlay must:
- have been made for the purpose of gaining or producing income from the business or property
- not be on account of capital
- not be made for the purpose of gaining or producing exempt income
- be reasonable in the circumstances
- not be a personal expense
A payment for damages will usually be on account of capital if it meets one of the accepted legal criterion for distinguishing a payment on account of capital from a payment on account of income; the payment:
- represents the acquisition cost or part of the acquisition cost of a capital asset
- creates an enduring benefit to the payer's business
- was made to preserve or protect a capital asset of the taxpayer
Cancellation of the contract is a disposition of the taxpayer's rights under the contract in accordance with the definition of disposition in subparagraph 248(1)(b)(ii) of the ITA.
A purchaser, who forfeits a deposit on cancellation of a contract, may sustain a capital loss or a deductible expense. This depends on the nature of the rights disposed of by the cancellation of the contract. For example, if the property that was to have been acquired under the contract would have been a capital asset to the purchaser, the purchaser's rights under the contract would generally be capital in nature. If the property would have been inventory to the purchaser or the cost of the property would have been otherwise deductible from income, the loss incurred on cancellation of the contract would generally be a deductible expense.
A forfeited deposit is not an eligible capital expenditure within the meaning of subsection 14(5) of the ITA. For more information, go to Income Tax Interpretation Bulletin IT143R3, Meaning of Eligible Capital Expenditure.
A taxpayer who is entitled to keep a deposit upon the cancellation of a contract may realize a capital gain on the forfeiture if the taxpayer's rights under the contract are capital in nature. Cancellation of the contract is a disposition of the taxpayer's rights under the contract in accordance with the definition of disposition in subparagraph 248(1)(b)(ii) of the ITA. The amount forfeited will be ordinary income if the rights disposed of under the contract are of an income nature.
The tax treatment of different types of extraordinary payments between landlords and tenants are discussed in Income Tax Interpretation Bulletin IT359R2, Premiums and Other Amounts with Respect to Leases. This includes payments made as consideration for the cancellation of a lease or sublease. Since lease cancellation payments are generally intended as compensation for loss or inconvenience resulting from the cancellation, they are included in the discussion of damage payments.
A premium or other amount that a landlord or tenant receives as consideration for cancelling a lease or sublease is considered business income to the recipient if the rental of property forms part or all of a business being carried on. Amounts that a landlord receives from a tenant for cancelling a lease or sublease always constitute income to the landlord.
When a tenant is not in the business of renting property, an amount the tenant receives from a landlord as consideration for the cancellation of a lease represents proceeds of disposition of part or all of the leasehold interest. Such dispositions are treated in the usual manner, depending on the nature of the leasehold interest and what the leasehold interest was being used for.
A tenant may pay an amount to cancel a lease or sublease. The tenant can deduct this amount when calculating income from a business or property provided the rent is so deductible. If the payment to cancel a lease or sublease is made in the context of a transaction that is capital in nature, the payment is considered capital in nature. For more information, go to:
- IT Ruling 2003-0043297, 2003-0011007
- Frankel Corp Ltd v MNR, 59 DTC 1161
- Johnston Testers Ltd v MNR, 65 DTC 5069 Exchequer Court
If a landlord pays an amount to a tenant to cancel a lease, the deduction is calculated in accordance with either paragraph 20(1)(z) or (z.1), depending on whether the landlord continues to own the property.
As long as the landlord, or a person, with whom the landlord does not deal at arm's length, continues to own the property, paragraph 20(1)(z) treats the payment as a prepaid expense. It may be deducted over the remaining of the term of the lease, subject to a maximum limit of 40 years.
When the property is sold, a deduction is permitted under paragraph 20(1)(z.1) in the year of disposition. The remaining balance of the lease cancellation payment is entirely deductible except for capital property; in this case, the deduction is equal to the capital gains inclusion rate times the balance remaining.
The auditor should be aware of the potential relating to unreported amounts for damage payments. Since these transactions are often of an extraordinary nature, they may not be subject to the same controls as regular business transactions. These transactions may be identified by the examination of documentation, such as the minute book and legal correspondence, or the analysis of accounts, such as professional fees, repairs and maintenance, and suspense. The auditor should also be alert to potential leads regarding other parties to the transaction.
Sometimes, a payment may be made on behalf of shareholders or officers of a corporation. Consequently, the auditor should consider whether or not a benefit has been conferred and determine the tax implications.
Income Tax Act
- Paragraph 14(5) - Definition of eligible capital expenditure
- Paragraph 20(1)(z) - Cancellation of lease
- Paragraph 20(1)(z.1) - Cancellation of lease
Income Tax Interpretation Bulletins
Income Tax Folio S2-F3-C2, Benefits and Allowances Received from Employment, discusses various types of fringe benefits and indicates whether or not their values should be included in income. The information contained in the folio refers to cases where there is an employee-employer relationship, but does not necessarily apply if the employee is also a shareholder or relative of the owner of the business. Except where the ITA provides otherwise, taxpayers are generally taxable on the value of all benefits they receive by virtue of their employment.
Employee benefits are generally taxable under paragraph 6(1)(a) of the ITA. However, certain employment benefits are taxable under other specific provisions of the ITA. For example, the automobile standby charge is included in income under paragraph 6(1)(e) and interest-free and low-cost loans are taxable in accordance with subsection 6(9).
If an amount in respect of a taxable benefit should be included in income, the employer must determine its value and include it on the employee's T4 slip. Taxable benefits are generally subject to Canada Pension Plan (CPP) or Quebec Pension Plan (QPP) contributions. With the exception of board and lodging, taxable benefits in kind are not insurable for employment insurance (EI) purposes.
If a benefit is required to be included in income, the benefit amount may be subject to goods and services tax (GST)/harmonized sales tax (HST) if the benefit includes a supply taxable for GST/HST purposes. The benefit reported includes the GST/HST and provincial sales tax (PST).
Subject to specific exceptions, the amount or value of any benefit conferred by a corporation on a shareholder is included in the shareholder's income under subsection 15(1) of the ITA. For common situations where such a benefit can arise, go to Income Tax Interpretation Bulletin IT432R2, Benefits Conferred on Shareholders.
Under subsection 15(1), the amount or value of a benefit conferred on a shareholder by a corporation in a tax year is included in the shareholder's income for the year, except to the extent that the benefit is deemed by section 84 to be a dividend. The shareholder benefit provision can also apply to a person who, at the time the benefit was conferred, was contemplated as becoming a shareholder.
If the person on whom the benefit has been conferred is both a shareholder and an employee of the corporation, a determination will have to be made, taking into consideration all the relevant facts and circumstances of the particular case, as to whether the benefit was conferred by the corporation on the person as a shareholder or as an employee. If as an employee, paragraph 6(1)(a) applies, rather than subsection 15(1).
For more information, go to 24.10.0, Benefits conferred on shareholders.
The value of the benefit derived by an employee from the personal use and availability of an automobile supplied by an employer is required to be included in calculating the employee's income. This value is an amount equal to a prescribed amount for each kilometre for operating costs in connection with personal use and a reasonable standby charge. The value of the automobile operating expense benefit is determined under paragraph 6(1)(k) of the ITA. The standby charge, which is brought into income under paragraph 6(1)(e), is calculated in accordance with subsection 6(2). In general, the standby charge is 2% a month of the cost of the automobile or 2/3 of the lease costs calculated, with reference to the number of days the automobile was available to the employee.
Standby charges may be reduced if the automobile is used more than 50% of the distance driven for business purposes and the kilometres for personal use do not exceed 1,667 for each 30-day period for a total of 20,004 kilometres a year or when the employee is engaged principally in selling or leasing automobiles. Before 2003, standby charges could be reduced when the personal use was less than 1,000 kilometres a month and the business-use portion of the total kilometres travelled was 90% or more.
As long as the automobile is used primarily (more than 50%) for business purposes, an amount equal to one-half of the standby charge benefit may be used as the amount of the operating cost benefit instead of the prescribed amount for each kilometre calculated. This option is available if the taxpayer notifies the employer in writing before the end of the year of the taxpayer's intention to make such an election.
For a detailed discussion of automobile benefits, go to Income Tax Interpretation Bulletin IT63R5, Benefits, Including Standby Charge for an Automobile, from the Personal Use of a Motor Vehicle Supplied by an Employer - After 1992.
As indicated in paragraph 18 of IT63R5, the guidelines in that interpretation bulletin may generally be applied to a shareholder of a corporation. Subsection 15(5) provides that, for the purposes of subsection 15(1), the value of the automobile benefit to be included in a shareholder's income is calculated in the same manner as automobile benefits received by an employee.
Other types of benefits
The following references are not meant to be exhaustive and refer to some of the benefits that may be received by employees and shareholders as a consequence of their employment or shareholdings.
Generally, all benefits received or enjoyed by an employee from an office or employment are taxable. However, subsection 6(6) of the ITA allows certain benefits related to special work sites or remote work locations to be excluded from income. Income Tax Interpretation Bulletin IT91R4, Employment at Special Work Sites or Remote Work Locations, discusses the conditions that an employee must meet to exclude from income benefits related to board, lodging, and transportation.
Income Tax Interpretation Bulletin IT421R2, Benefits to individuals, corporations and shareholders from loans or debt, discusses the taxation of benefits arising from certain interest-free or low interest loans or debts.
The auditor should consider carrying out the following procedures during the audit:
- review capital assets to determine if there is potential for personal use of employer owned assets, such as automobiles and vacation properties
- review expenses for items, such as personal travel or travel of persons other than employees that may accompany employees
- determine if employees accumulate frequent flyer points for personal use
- review T4 slips to make sure that the employer has correctly reported benefits
- review capital asset acquisitions to make sure that passenger vehicles are classified appropriately and that benefits are calculated on the full cost
- determine if the employer pays or reimburses employees for educational costs or tools
- determine if the employer provides any of the following to employees:
- board and lodging
- rent-free or low-rent housing
- gifts, prizes, or incentive awards
- medical insurance when the premium is paid by the employer
- interest-free or low-interest loans
- financial counselling or preparation of income tax returns
- a wage-loss replacement plan
If problems are encountered relating to employee benefits, consider a referral to the Employer Compliance Audit section in the tax services office (TSO).
For more information about the audit of employee benefits and consultations with the Accounts Receivable Division concerning the Employer Compliance Audit program, go to 12.2.0.
The following examples are based on the calculation of automobile benefits calculated in non-participating provinces and include GST at 5% and PST at 8%. The GST and PST components are replaced by the applicable HST rate in participating provinces. Since January 1, 2013, the Quebec sales tax (QST) is calculated directly on the selling price not including GST. The QST rate has been raised from 9.5% to 9.975%.
The standby charges in the following examples may not be reduced, since business use of the automobile is not more than 50% of the distance driven.
Example 1 - Standby charge employer-owned vehicle
- The automobile was acquired in 2010 at a cost of $45,000.
- GST (5%) $2,250.
- PST (8%) $3,600.
- The employer is a corporation.
- The employer has claimed the maximum input tax credit (ITC) of $1,500, as prescribed for passenger vehicles. No recapture or claw-back is required.
- The automobile was available for use by the employee during all 12 months of 2011.
- The employee has not reimbursed the employer any portion of the standby charge.
- Total kilometres driven during the year: 40,000.
- Personal kilometres during the year: 20,500 (51%).
- The reduced standby calculation does not apply to this situation.
($45,000 + GST + PST) x 2% x 12 = $12,204 (ITA Regulation 7306)
GST to be remitted by the employer
$12,204 x 4/104 = $469 (Excise Tax Act (ETA) subsection 173(1))
Example 2 - Standby charge leased automobile
- The lease commenced in July 2010.
- Monthly lease cost is $900.
- GST (5%) $45.
- PST (8%) $72.
- The employer has claimed the maximum ITC of $40, as prescribed for passenger vehicles. No recapture or claw-back is required.
- The automobile was available for use by the employee during all 12 months of 2011.
- The employee has not reimbursed the employer any portion of the standby charge.
- Total kilometres driven during the year: 40,000.
- Personal kilometres during the year: 20,500 (51%).
- There is no insurance component included in the lease costs.
- The reduced standby calculation does not apply to this situation.
2/3 x (($900 + GST + PST) x 12) = $8,136
GST to be remitted by the employer
$8,136 x 4/104 = $313
Example 3 - Operating cost benefit
- The employer owns the automobile.
- The applicable standby charge is $12,204.
- Total operating costs: $5,600.
- Personal kilometres during the year: 20,500 (51%).
- The employee has not reimbursed the employer any portion of the operating costs.
Personal km 20,500 x $.24 = $4,920 (ITA Reg. 7305.1)
The operating benefit of $4,920 includes GST of $148 (prescribed rate of 3% of the benefit amount) (ETA Regulations SOR/99-176 s.2).
The employer is required to remit GST of $148, equal to 3% of the operating cost benefit, or HST in the applicable amount, according to the ETA Regulations.
Example 4 - Operating cost benefit with employee reimbursement
- The employer owns the automobile.
- The applicable standby charge is $12,204.
- Total operating costs: $5,600.
- Personal kilometres during the year: 20,500 (51%).
- The employee has reimbursed the employer $1,800 for operating costs.
Personal km 20,500 x $.24 = $4,920 - $1,800 = $3,120
The operating benefit of $3,120 includes GST of $94 (prescribed rate of 3% of the benefit amount).
The employer is required to remit GST of $148 (same as example 3) in respect of both the benefit and the reimbursement.
Lowe v The Queen, (FCA) 1996, 96 DTC 6226
The taxpayer and his spouse spent an overwhelming portion of time in New Orleans devoted to business activities. Based on this fact, the court ruled that no part of the trip expenses were to be regarded as a personal benefit. The personal benefit to the employee and his spouse was considered merely incidental to the business purpose of the trip.
Mommersteeg et al v The Queen, (TCC) 1996, 96 DTC 1011
The taxpayer received airline travel as a result of frequent flyer points acquired while travelling on employer related business. The benefit to the employee was established as the amount the employee would have had to pay to purchase a ticket to travel on the same flight, in the same class, and subject to the same restrictions.
The Queen v Blanchard, (FCA) 1995, 95 DTC 5479
The employee received $7,240 from his employer as part of a housing program termination package that was included in his income. The payment arose from an agreement entered into at the time of or before the period of his employment. It represented the value of certain contractual rights that were a benefit to him.
The Queen v Huffman, (FCA) 1990, 90 DTC 6405
The employee received $500 from his employer to assist in defraying the cost of clothing worn on the job. The employee spent more on clothing than the $500 he received from his employer. The court considered the $500 a reimbursement and concluded that the employee did not receive any economic benefit.
The Queen v Phillips, (FCTD) 1994, 94 DTC 6177
The CNR assisted the employee with the purchase of a home in Winnipeg to replace the one sold in Moncton because of the employee's relocation to the Winnipeg facility following the closure of the Moncton facility. The sum was considered a taxable benefit since the taxpayer's net worth increased by $10,000 and did not simply restore him to his previous financial state.
Vickery v The Queen, (TCC) 1993, 93 DTC 993
Via Rail gave the taxpayer the option of receiving a $22,000 lump sum payment or certain relocation benefits because of changes to passenger services. The taxpayer chose the lump sum payment. The payment was required to be included in income since it was not a reimbursement of expenses incurred by the taxpayer.
Income Tax Act
- Paragraph 6(1)(a) - Value of benefits
- Paragraph 6(1)(e) - Standby charge for automobile
- Paragraph 6(1)(k) - Automobile operating expense benefit
- Paragraph 6(1)(l) - Automobile benefit
- Subsection 6(2) - Reasonable standby charge
- Subsection 6(6) - Employment at special work site or remote location
- Subsection 6(7) - Cost of property or service
- Subsection 6(9) - Amount in respect of interest on employee debt
- Subsection 15(1) - Benefit conferred on shareholder
- Subsection 15(1.3) - Cost of property or service
- Subsection 15(5) - Automobile benefit
- Subsection 15(9) - Deemed benefit to shareholder by corporation in respect of a loan or debt
- Section 80.4 - Loans
- Regulation 7305.1
- Regulation 7306
Income Tax Interpretation Bulletins
- IT63R5, Benefits, Including Standby Charge for an Automobile, from the Personal Use of a Motor Vehicle Supplied by an Employer - After 1992
- IT91R4, Employment at Special Work Sites or Remote Work Locations
- IT421R2, Benefits to individuals, corporations and shareholders from loans or debt
- IT432R2, Benefits Conferred on Shareholders
The term Employment refers to the relationship that exists between, what in common law is referred to as master and servant. For purposes of this discussion, the terms employer and employee are used.
The relationship between the parties is not always clear. Each situation is unique. The facts must be reviewed together with other factors. Although some situations may be factually similar, factors that may not be readily apparent will affect the decision about the type of relationship that exists. If an employer-employee relationship exists between two parties, is a question of fact.
CPP/EI rulings officers in the TSO (Accounts Receivable Division, CPP/EI Rulings Section) are responsible for determining if an individual is an employee or self-employed individual; that is, operating their own business. The individual or the payer/employer usually request such a determination. The taxpayer has the right to have the law applied consistently according to the Taxpayer Bill of Rights.
Income from self-employment is considered to be business or professional income (as opposed to employment income in the case of an employee). Self-employed individuals are allowed to deduct all reasonable expenses incurred for the purposes of gaining or producing income from business (except capital outlays), whereas employees are limited to the specific deductions set out in section 8 of the ITA.
Basic knowledge of the issues and criteria used to make employee or self-employed individual determinations is required when the auditor encounters situations where the parties may not be in compliance with legislation. In situations where non-compliance is suspected, a referral should be made to Rulings. Using the questionnaire in Tax Guide RC4110, Employee or Self-employed?, may be helpful in determining whether a referral is necessary.
Contract of service (employer-employee) vs contract for services (self-employed individual)
Employees usually work under a contract of service for a salary or some other form of remuneration. A contract of service is an arrangement whereby an individual agrees to work for the other party for a period of time. Generally, an employee-employer relationship contemplates putting the employee's services at the disposal of the employer on an ongoing basis, but without reference to achieving a specific result. A self-employed individual relationship, however, is normally considered to exist when both parties agree that certain specified work will be undertaken.
A contract for services is an arrangement in which one party agrees to perform work specified in the contract for another party. It does not usually require that the contracting party perform the work personally. The self-employed individual uses discretion and initiative in determining how and by whom the work is to be performed. The contract specifies that a given result be achieved within a set period of time and the fee paid for services when completed. The contractor's profit depends on the efficiency in completing the services.
A contract may be written or oral. In general, an oral contract exists when there is a verbal agreement between the parties to the contract as to the services that are to be performed and the remuneration that is to be given in return for those services. Some written contracts stipulate that the parties agree that the relationship is a contract for the performance of a service and that the contractor is not considered an employee. In these cases, the contract must be examined and analyzed together with the facts in the case to verify the nature of the arrangement between the parties.
Some contracts contain elements of a contract of service, as well as a contract for services. One such example is a contract between an employment agency and its workers. The worker is employed and remunerated by the agency, but the aspect of control is the responsibility of the client of the employment agency.
Some of the issues that should be considered when determining if an individual is an employee or self-employed individual, include the following:
- ownership of tools
- chance of profit and risk of loss
In an employer-employee relationship, the employer controls the way the work is done. The entitlement to exercise control indicates an employer-employee relationship. The degree of control may vary depending on the type of work and the employee's experience and skill.
Generally, control is exercised when the payer has the right to hire or fire, determine the wage or salary to be paid, and decide on the time, place, and manner in which the work is to be done. Some specific examples of exercising control include:
- setting the hours of work
- assessing the quality of work
- requiring workers to give periodic activity reports
- determining the clients and the territory covered
- providing training and development
In a business relationship, the payer does not usually exercise control over the self-employed individual's activities. The payer may supervise the work, but only to make sure that the self-employed individual carries it out in accordance with the contract.
2. Ownership of tools
The main issues to consider for the ownership of tools, are the:
- amount invested
- value of equipment and tools
- rental and maintenance of equipment and tools
In an employer-employee relationship, the employer normally supplies the equipment and tools required by the employee. The employer usually pays transport, rental, operating, repair, and insurance costs. However, for some tradespeople, such as garage mechanics, painters, and carpenters, or professionals, such as computer scientists, architects, and surveyors, it is customary for employees to supply and use their own tools or software and instruments, as required to complete the tasks assigned.
3. Chance of profit and risk of loss
The third criterion in determining the nature of the relationship is an examination of the worker's financial involvement and any associated risks. Points that are considered include whether:
- the worker has a chance of making a profit
- losses due to bad debts, damaged equipment, delays in delivery of materials, or delays from suppliers are the worker`s responsibility
- the worker pays operating costs (office expenses, employee wages and benefits, insurance premiums, delivery and shipping costs)
In an employer-employee relationship, the employer assumes any risk of loss. The employee assumes no financial risk and is entitled to full salary or wages regardless of the financial health of the business. An employee whose remuneration depends on the number of units processed or is based on sales (commission), does not depend on profits or losses of the business. While the employee's remuneration may depend on volume of production or sales, the remuneration does not depend on the profitability of the employer.
The integration test examines if the individual doing the work is economically dependent on the organization. The more dependent the individual is on the organization, the more likely the individual will be considered to be an employee.
The case summary in Sagaz Industries Canada Inc. v 671122 Ontario Ltd., 2001 SCC 59 indicates, "There is no one conclusive test which can be universally applied to determine whether a person is an employee or an independent contractor. What must always occur is a search for the total relationship of the parties. The central question is whether the person who has been engaged to perform the services is performing them as a person in business on his own account. In making this determination, the level of control the employer has over the worker's activities will always be a factor.
However, other factors to consider include whether the worker provides his or her own equipment, whether the worker hires his or her own helpers, the degree of financial risk taken by the worker, the degree of responsibility for investment and management held by the worker, and the worker's opportunity for profit in the performance of his or her tasks."
Another case that should be reviewed, that dealt with the issue of whether the taxpayer was an employee or an independent contractor, is Wolf v The Queen, 2002 DTC 6853.
Exhibit 1 - Criteria of a contract of service (Employer's point of view)
When attempting to determine if a taxpayer is under a contract of services of an employed individual, certain factors may be considered, which on their own are inconclusive, but when taken together, support an employer-employee relationship. Some of the factors which should be considered in making this determination include:
- wages or salary
- hourly, daily, weekly, monthly, annual
- by the piece
- by the trip
- lump-sum payments
- contract basis
- in kind
- selecting, hiring, paying, and dismissing employees
- consequences of one's actions
- accepting losses and other risks
- entitlement to profits
- seeing work through to completion
- safety in the workplace and welfare of employees
- deciding how the work is to be done
- hours, days
- full-time, part-time
Verbal and written instructions
- on the road
- opinion of the payer
- opinion of the worker
- worker's compensation
- QPP and CPP
- group accident, health, and dental insurance
- registered pension plans
- profit-sharing plans
- collective agreements
- written reports
- verbal reports
- hiring of others
- services performed for others
- choice of location
- choice of schedule
- choice of work method
- requirement of personal services
Ownership of the business
The ownership of the business is of vital importance when determining the nature of the relationship between superior and subordinate. The crucial question is: Does one of the parties operate the business for their own benefit and not solely for the superior?
In a business relationship, the self-employed individual may make a profit or incur a loss. The individual pays operating costs and usually supplies their own equipment and tools and pays the expenses related to their use. There is no guarantee of income because the income depends on the completion of the contract, the responsibility which is borne by the self-employed individual.
The self-employed individual may undertake several projects simultaneously to increase profit. The individual may market their services provided and must complete the work stipulated in a contract, while an employee may resign at will.
Where the self-employed individual combines the payer's activities with their own business activities, a business relationship is likely to exist. The individual does not depend on the payer's business.
Factors that assist in providing audit evidence that a contract for service exists are as follows:
- A self-employed individual is required to produce a given result within a specified period of time.
- There is no direct control over the work by the payer and the payer is not normally involved in the performance of the work.
- A self-employed individual uses discretion to produce a given result in a manner considered most appropriate.
- A self-employed individual is not under orders or control of the person for whom the work is being done and is free to use initiative in matters not specified by the contract.
- A self-employed individual assumes the chance of profit as well as the risk of loss by agreeing to a fee as specified by the contract.
- A self-employed individual is responsible for losses resulting from events that may occur during the work and benefits from increased profits, if the work is completed more quickly or at a lower cost than anticipated.
- A contract for service is often used when the work does not fall within the domain of the organization requiring the service.
- The payer does not have the authority to stipulate the manner in which the work is done.
- The person for whom the work is being done may provide general supervision to make sure that the work is completed in accordance with the agreement, but may not give orders regarding the manner in which the work is done.
- General instructions regarding the work do not indicate an employer-employee relationship.
The relationship between the parties has implications under the ITA, as well as the Employment Insurance Act, Canada Pension Plan Act, and numerous provincial acts and related statutes.
If an employer-employee relationship exists, the employer has certain responsibilities, including:
- register to obtain a CRA business number
- withhold income tax, CPP or QPP contributions, and EI premiums on salary and wages paid to employees
- remit the amounts withheld, as well as the employer's share of CPP/QPP contributions and EI premiums, to the CRA and the Minister of Revenue of Québec, as applicable
- report the employees' income and deductions on the appropriate information return
- provide employees with a copy of their T4 slip by the end of February of the year following the year salary or wages were earned
If the payer considers a worker self-employed when, in fact, an employer-employee relationship exists, the payer will be required to pay both the employer and employee portion of EI premiums and CPP/QPP contributions, including any applicable penalty or interest.
Certain employer-employee relationships are excluded by the Employment Insurance Act for purposes of EI benefits. The most common exclusion is a non-arm's length relationship. In some circumstances, and if the conditions of employment are reasonable, the relationship may be included for purposes of EI benefits payable.
Some of the income tax implications to an employee if an employee-employer relationship exists include:
- only deductions specifically authorized by the ITA can be claimed from employment income
- income from employment is taxed based on the cash method of accounting
- tax is withheld from employment income at the source of payment
Individuals who are self-employed:
- may deduct all reasonable expenses incurred for the purpose of gaining or producing income from business, unless the expenditures are specifically not allowed under the ITA
- may be required to make instalment payments of income tax
- will usually report their income based on the accrual method of accounting
- do not qualify for EI benefits
- must pay both the employer and employee portion of CPP/QPP contributions
Special rules relating to EI, CPP/QPP, and income tax may apply to certain categories of self-employed individuals, including:
- barbers and hairdressers
- taxi drivers and drivers of other passenger-carrying vehicles
- placement and employment agency workers
For more information about these types of self-employed individuals, refer to Chapter 6 in Tax Guide T4001, Employers' Guide - Payroll Deductions and Remittances.
Under section 238 of the Income Tax Regulations, an individual, partnership, trust, or corporation whose primary business activity is construction, must file an information return reporting payments made to subcontractors for construction services. An information return consists of:
When undertaking an audit of a taxpayer that uses the services of a self-employed individual, the following should be considered:
- make sure that the relationship qualifies as a business relationship, rather than an employer-employee relationship
- determine if the applicable deductions (CPP/QPP, EI, and income tax) are being withheld, if the self-employed individual has employees
- refer the case to CPP/EI Rulings, if there are any concerns regarding the status of the relationship
- Wiebe Door Services Ltd. v MNR, 87 DTC 5025
- Wolf v The Queen, 2002 DTC 6853
- Sagaz Industries Canada Inc. v 671122 Ontario Ltd., 2001 SCC 59
- Tax Guide RC4110, Employee or Self-employed?
- TOM 23(41)
Taxpayers are allowed to report income from a farming or fishing business for income tax, using the accrual or cash method of accounting.
Definition of farming and fishing
Go to the definition of farming in subsection 248(1) of the ITA. The definition is not meant to be exhaustive; consequently, other activities have been characterized by the courts as farming, including the following:
- tree farming
- cultivating crops in water or hydroponics
- operating a wild game reserve
- operating a chicken hatchery
- under certain circumstances, the operation of a nursery and a greenhouse or market gardening
Farming does not include trapping or an office or employment in a farming business.
Go to the definition of fishing in subsection 248(1) and note that it does not include an office or employment in a fishing business.
Cash method of accounting
Subsection 28(1) of the ITA allows the cash method of accounting to be used in computing the income or loss from a farming or fishing business. Under the cash method of computing income, amounts are included in income in the fiscal period received, expenses are deducted from income in the fiscal period paid, and certain adjustments are made for non-cash items (such as capital cost allowance).
The legislation also includes two inventory adjustments for farmers who use the cash method of accounting to determine farming income. The first, which may be used to average income, is optional and applies to a farmer's inventory on hand at the end of the year. The second is a mandatory adjustment to inventory, in loss years only, for purchased inventory on hand at the end of the year. The amounts added to income in a year for the optional and mandatory inventory adjustments must be deducted in computing the income for the following year. The optional and mandatory inventory adjustments do not apply in a year in which a farmer dies.
Farmers or fishers who use the cash method of accounting for reporting income, cannot always deduct a prepaid expense amount (other than for inventory). Subparagraph 28(1)(e)(iii) limits this to the amount that would be deductible, if not using the cash method, for the current and following year. Paragraph 28(1)(e.1) allows prepaid expense amounts, paid in previous years, to be deducted in the current year.
For example, a farmer rents 10 hectares of land from a land owner in order to increase crop production. The cost is $1,500 per year for each of the five years. The farmer pays the entire amount, $7,500, up front, in February 2013. The portion that would otherwise be deductible is $1,500 per year. The farmer cannot deduct the amount paid ($7,500), as subparagraph 28(1)(e)(iii) limits the deduction to the amounts for 2013 (current year) and 2014 (following year) ($1,500 + $1,500 = $3,000). There is no deduction allowed in 2014, as subparagraph 28(1)(e.1)(ii) excludes amounts that were deductible for any other year (and the 2014 portion was deducted in 2013). For each of the 2015-17 years, the farmer can deduct $1,500, in accordance with paragraph 28(1)(e.1).
Once a taxpayer files a return using the cash method of accounting to calculate income from a farming or fishing business, this method must be used in subsequent tax years, unless the taxpayer receives permission from the minister to adopt the accrual method of accounting. To change from the cash to accrual method, approval must be requested in writing from the director of the local TSO before the tax return is filed, specifying the reasons for the change. Permission is not required to change from the accrual to the cash method of accounting.
If a taxpayer changes from one method of reporting to another in a tax year, the taxpayer must submit a statement with the income tax return indicating each adjustment that was made to income and expenses because of the difference in methods.
The cash method of accounting is not applicable to a farming or fishing business operated as a partnership, unless each partner elects to have the income from the business computed in accordance with this method.
For more information about the cash method of accounting and inventory adjustments, go to Income Tax Interpretation Bulletin:
Revision of the optional inventory adjustment
If there is an upward reassessment of tax because of an audit of a taxpayer carrying on a farming business, the taxpayer is given the opportunity to revise the amount specified (optional inventory adjustment) under paragraph 28(1)(b) to offset the upward reassessment, provided the request is made in writing prior to the reassessment or within the time for filing a notice of objection for the particular year.
If a taxpayer requests a revision to the optional inventory adjustment in a year which was assessable to tax, such requests will be allowed if the time has not expired for filing a notice of objection for that year. If the request to revise the optional inventory adjustment is accompanied by a request to some other permissive deduction, resulting in no change to the tax assessed for the year or any other year for which the time for filing a notice of objection has expired, such requests will normally be allowed.
If a taxpayer requests a revision to the optional inventory amount in a year which was assessable to nil income tax (because of a loss in that year or the application of a loss of another year), such requests will be allowed only if there is no resulting change in the tax assessed for the year or any other year of the taxpayer for which the time for filing a notice of objection has expired.
All requests for revisions must be made in writing. If a taxpayer wants to request a revision to the optional inventory adjustment in a prior year that is within the limits described above, the taxpayer should send a letter to the director of the TSO. The letter should set out the pertinent information concerning the requested revisions along with any other schedules which are affected by the revision.
The Taxpayer Bill of Rights states that the taxpayer has the right to receive entitlements and to pay no more and no less than what is required by law. For more information, go to Taxpayer Bill of Rights.
Deferred cash purchase tickets
Subsection 76(4) provides for the deferral of income if cash purchase tickets and other forms of settlement prescribed pursuant to the Canada Grain Act or by the minister are issued for grain delivered to a primary or a process elevator. It applies to taxpayers carrying on a farming business who elect under subsection 28(1) to use the cash method of accounting to report income.
If the ticket issued by the primary or process elevator is for the sale of grain (wheat, oats, barley, rye, flaxseed, and rapeseed) produced in designated areas, and the holder of the ticket is entitled to payment by the elevator operator of the amount stated on it, without interest, at a date that is after the end of the tax year in which the grain is delivered, subsection 76(4) requires that the taxpayer exclude the amount stated on the ticket from the income of the tax year in which the grain was delivered and include it in the income of the immediately following tax year.
If a levy applies to the cash purchase ticket under the Western Grain Stabilization Act, the levy is considered paid upon receipt of the ticket and is deductible in the year delivery for sale occurs.
For more information, go to Income Tax Interpretation Bulletin IT184R, Deferred cash purchase tickets issued for grain.
Under the Agricultural Marketing Programs Act, a farmer may receive cash advances for crops that someone stores in the farmer's name. CRA considers these advances to be loans. These payments are not to be included in the farmer's income until the crops are sold. However, for the fiscal period in which the sale occurs, the full amount from the sale of the farmer's crops is included in the farmer's income.
For the CRA's administrative policy related to government assistance, go to Income Tax Interpretation Bulletin IT273R2, Government Assistance - General Comments. The bulletin deals with the tax treatment of inducements and other forms of government assistance received by a taxpayer in the course of earning income from a business or property. It discusses the taxability of such assistance and the consequences of repayments. The rules allowing the taxpayer to reduce the cost of property when such assistance is received with respect to the acquisition of capital property are also explained.
Paragraph 12(1)(x) of the ITA provides that certain inducements, reimbursements, assistance, etc., received by a taxpayer in the course of earning income from a business or property must be included in income to the extent that the amounts have not otherwise been included in income, reduced the cost of a property, or the amount of an expense.
Ceasing to carry on a farming or fishing business
If a taxpayer, who reports income from a farming or fishing business using the cash method of accounting, disposes of, or ceases to carry on, all or part of the business, the amount received for the accounts receivable that would have been income is income to the taxpayer in the year of receipt, pursuant to subsection 28(5). This is income whether it is received from the sale of a business as a going concern, or from the separate sale or later collection of the accounts receivable.
A taxpayer, who reports income from a farming or fishing business using the cash method of accounting, may dispose of, or cease to carry on, the business or part of it before the accounts receivable are fully collected. Where such a taxpayer ceased to reside in Canada or ceased to carry on such a business in Canada after July 13, 1990 and, at the end of the tax year, is non-resident and does not carry on that business in Canada, an amount for the uncollected accounts must be included in the taxpayer's income by virtue of subsection 28(4).
Subsection 10(12) applies to a non-resident taxpayer who ceases to use a property, described in the inventory of a business or part of a business that is carried on by the taxpayer in Canada, otherwise than by a disposition of property. If subsection 10(12) applies, the taxpayer is deemed to have disposed of the property immediately before the particular time, for proceeds of disposition equal to the property's fair market value at that time. The taxpayer is deemed to have received the proceeds in the course of carrying on the business in which the property was formerly used, in the tax year that includes the particular time.
When reviewing the books and records of a farming business, auditors should determine if these amounts received have been correctly reported:
- subsidies and other stabilization programs
- crop insurance and other insurance proceeds
- payments received for destroying livestock under the Health of Animals Act
- custom or contract work, including trucking
- machine and equipment rentals
- rental income, including surface rental for petroleum or natural gas exploration
- patronage dividends
- sales of wood, soil, sand, gravel, or stone
- prizes from fairs or exhibitions
When reviewing the books and records of a fishing business, auditors should determine if these amounts received have been correctly reported:
- grants and subsidies
- insurance proceeds
- patronage dividends
- sales of property that was expensed
- shareholder income
Income Tax Act
- Subsection 28(1) - Computing income from a farming or fishing business
- Subsection 76(4) - Debt deemed not to be income debt
- Subsection 248(1) - Definition of farming and fishing
Income Tax Interpretation Bulletins
- IT184R, Deferred cash purchase tickets issued for grain
- IT200, Surface rentals and farming operations
- IT273R2, Government Assistance - General Comments
- IT373R2-CONSOLID, Woodlots
- IT417R2, Prepaid Expenses and Deferred Charges
- IT425, Miscellaneous farm income
- IT427R, Livestock of Farmers
- IT433R, Farming or Fishing - Use of Cash Method
- IT526, Farming - Cash method inventory adjustments
For accounting purposes, every transaction involving foreign currency must be restated in Canadian dollars at the exchange rate applicable on the date of the transaction or at an average rate. The generally accepted accounting principles (GAAP) for foreign currency translation are governed by section 1651 of the CICA Handbook.
The Currency Act requires transactions in foreign currencies to be converted to Canadian dollars for all public accounts.
There is no specific legislative reference in the ITA requiring Canadian dollar reporting. However, the ITA is a Canadian statute and therefore, in general terms, it is the CRA's opinion that a taxpayer's taxable income should be expressed in Canadian dollars. There are several court cases that support the CRA's opinion that transactions should be measured in Canadian currency. Alberta Gas Trunk Line Co Ltd v MNR, 71 DTC 5403, supports the CRA's view that income or losses must be measured in Canadian dollars for Canadian tax purposes. In The Queen v The Bank of Nova Scotia, 81 DTC 5115, it was established that for Canadian tax purposes, the foreign currency profit and losses must be expressed in terms of Canadian currency. Consequently, if a transaction occurs in a foreign currency, the Canadian dollar value of the transaction is calculated according to the exchange rate prevailing at the time of the transaction.
For income tax purposes, the main focus is to determine if the exchange gain or loss is on account of income or capital.
The following guidelines should be read with Income Tax Interpretation Bulletin IT95R, Foreign Exchange Gains and Losses.
There is no specific provision in the ITA that stipulates whether a gain or loss from a foreign currency transaction is considered on account of capital or income; the basic principles of determining income from a business or property for purposes of subsection 9(1) must be applied. Subsection 39(2) provides the rules for calculating capital gains and losses in respect of foreign currencies.
The main issue in determining the income tax status of foreign currency exchange gains or losses is the identification of the transactions from which they resulted, or, in the case of funds borrowed in a foreign currency, the use of the funds.
A related issue is the determination of the accounting method to be used for tax purposes for reporting the foreign exchange gains or losses.
In general, the question of whether the foreign exchange gain or loss is on account of income or capital will depend primarily on the character of the transaction that it arose from. If a gain or loss results on the purchase or sale of capital assets, the transaction is on account of capital. If there is a gain or loss on foreign exchange as a consequence of the purchase or sale of goods, or the rendering of services, and such goods and services are used in the business operations of the taxpayer, the gain or loss is generally considered on account of income. A significant number of court cases have dealt with the various issues involved.
The method used to determine foreign exchange gains or losses on income transactions must be in accordance with GAAP and should be the same for financial statements and income tax purposes. Some of the accounting methods that may be appropriate to determine foreign exchange gains and losses on income transactions are as follows:
a) A taxpayer's transactions on income account are recorded in their accounts in the Canadian dollar equivalent, determined according to the rate of the exchange prevailing at the time of the transaction. If full or partial settlement (that is, receipt or payment of Canadian dollars) of an account is made within the tax year, any foreign exchange gain or loss is reflected in income in that tax year and at the end of the year, the normal practice is for a taxpayer to adjust to Canadian dollars all their current accounts to reflect the exchange rate prevailing at that time and to include any resulting foreign exchange gains or losses in income in the year (current rate or accrual method). Any mark-down for inventory to fair market value or net realizable value may result in an exchange gain or loss on the date of valuation.
b) A taxpayer may record transactions throughout the year at a fixed rate, which does not necessarily approximate the prevailing rate at the time.
c) A taxpayer may record transactions throughout the year at an average rate of exchange during the year. This method is not acceptable if exchange rates fluctuate significantly during the year.
If either b) or c) above is used by a taxpayer, an adjustment of all accounts to Canadian funds must be made at the end of the year at the prevailing exchange rate at that time.
For more information about these methods, read paragraphs 8 and 9 in Income Tax Interpretation Bulletin IT95R, Foreign Exchange Gains and Losses.
While both International Accounting Standard (IAS) 21 and section 1651 call for recognition of an exchange gain or loss at each period end for amounts that have not yet been settled, subsection 39(2) of the ITA considers that a taxpayer has incurred a gain or loss in a foreign currency only if there has been a transaction resulting in a gain or loss. As a result, the CRA does not require the recognition of income if there has merely been a paper gain/loss, and the accrual method of accounting is not acceptable for purposes of reporting foreign exchange gains or losses on account of capital.
For example, when the US$ exchange rate was $0.90, Corp X purchased a capital property for $900,000 US. The corporation should record the transaction in Canadian dollars:
Capital Property 1,000,000
Account payable 1,000,000
At the end of the period, the exchange rate is now $1CAN = $0.92US. At this rate, the payment of Canadian dollars to cover the US$900,000 debt would be $978,260. GAAP requires that an adjustment be made to recognize this $21,740 gain into income. However, as the debt will not be paid until some subsequent period, there is no recognition of this amount for the ITA.
Forward contract and currency swaps
Foreign exchange gains or losses on foreign currency loans to finance investments are generally considered to be on account of capital. There are several court cases that have reviewed the subject of foreign exchange gains or losses on forward contracts and currency swaps. In a number of cases, the courts have ruled that if the forward contract and currency swap are an integral part of the foreign currency debt issue (that is, they hedge the amount of foreign exchange gain or loss on the debt), then they should be taxed in the same way as the debt.
However, in Salada Foods Ltd v The Queen, 74 DTC 6171, the Court found little relationship between the gain on a foreign exchange forward contract and the investment in a U.K. subsidiary. In MacMillan Bloedel Ltd v The Queen, 90 DTC 6219, the Court ruled that a forward contract was a separate transaction from an anticipated foreign exchange borrowing, although incurred in the course of such borrowing. The Court ruled that the foreign exchange loss was deductible under subparagraph 20(1)(e)(ii). In Netupsky v The Queen, 92 DTC 2282, the court held that there were two separate and distinct transactions, borrowing and the foreign exchange speculation.
Forgiveness of debt - Foreign currency
Section 80 sets out the rules that apply when an obligation of a debtor is settled or extinguished for less than its principal amount. Paragraph 80(2)(k) applies if the obligation is denominated in a foreign currency. It provides that foreign currency fluctuations, after the time an obligation is issued, are ignored for the purposes of section 80 and that forgiven amounts are determined with reference to the exchange rate at the time the debt was issued.
There have been numerous court decisions over the years that provide guidance on the determination of exchange gains either as being on account of income or capital. Cases that deal with this subject include:
- Canadian General Electric Co Ltd v MNR, 61 DTC 1300
- D W S Corp v MNR, 68 DTC 5045
- ISE Canadian Finance Ltd v MNR, 86 DTC 1344
- Eli Lilly and Co Ltd v MNR, 55 DTC 1139
- Canadian Gypsum Co Ltd v MNR, 65 DTC 5125
- Tip Top Tailors Ltd v MNR, 57 DTC 1232
- Aluminium Union Ltd v MNR, 60 DTC 1138
- Neonex International Ltd v The Queen, 78 DTC 6339
- Ethicon Sutures Ltd v The Queen, 85 DTC 5290
- Columbia Records of Canada Ltd v MNR, 71 DTC 5486
- Canadian SKF Co Ltd v MNR, 66 DTC 140 (TAB)
Auditors must carefully examine all aspects of the various transactions that gave rise to any foreign exchange gains or losses. A review of the minute book may disclose significant capital expenditures or details of the transactions. The auditor must review how the taxpayer has treated past gains or losses to make sure that the method chosen is used consistently. If it is not, the auditor should discuss this with the taxpayer. Only when all the facts have been gathered, can it be determined if the exchange gain or loss is on account of income or capital.
Income Tax Act
- Subsection 9(1) - Income
- Subparagraph 20(1)(e)(ii) - Expenses re financing
- Subsection 39(1) - Meaning of capital gain and capital loss
- Subsection 39(2) - Capital gains and losses in respect of foreign currencies
- Subsection 40(1) - General rules calculation of gain, loss, or reserve
- Subsection 40(2) - Limitations
- Paragraph 115(1)(b) - Non-resident's taxable income in Canada
Income Tax Interpretation Bulletins
Income Tax Ruling
- 9208706, March 27, 1992, Non-Resident - Foreign Exchange Gain Or Loss
- Memorandum, Financial Industries Division (P&L Branch), September 18, 1995, CCH 
For a summary of CRA's views on the case law dealing with foreign exchange gains, see CCH Window on Canadian Tax, Issue Sheet, Rulings Directorate December 16, 1991 . Even though the cases referred to are prior to 1991, they are still relevant today.
A lawyer incurs various expenses to provide legal services and some of which may be reimbursed by the client.
There is no direct income tax implication resulting from the GST/HST treatment of lawyers' disbursements. Income Tax Interpretation Bulletin IT129R, Lawyers' trust accounts and disbursements provides information on the proper method of reporting income and expenses for income tax purposes with respect to trust funds and disbursements and with respect to funds held for clients involved in litigation.
Income Tax Interpretation Bulletin
- August 9, 2000, CN8400, Lawyers' disbursements - Expert witness
- December 2, 1997, HQR0000744 - Lawyers' disbursements
An inducement payment is an economic incentive to persuade a person to take a specific course of action. Government subsidies to a business to establish operations in a particular location or a payment made by a landlord to a tenant to enter into a lease are examples of inducement payments.
The tax treatment of inducement payments has always been difficult to establish. Over the years, however, the situation became continually more complicated as new types of inducement payments appeared as well as the publication of certain legal decisions on the subject.
The government, therefore, introduced paragraph 12(1)(x) of the ITA to clarify the income tax treatment of amounts received by a taxpayer as an inducement. The taxpayer has the right to have the law applied consistently according to the Taxpayer Bill of Rights.
Paragraph 12(1)(x) of the ITA provides that certain amounts that can reasonably be considered to have been received by a taxpayer in the course of earning income from a business or property as an inducement, refund, reimbursement, contribution, or allowance or as assistance, shall be included in income to the extent that the amount :
- has not otherwise been included in computing the taxpayer's income, or deducted in computing any balance of undeducted outlays, expenses, or other amounts
- does not reduce the cost or capital cost of the property or the amount of the outlay or expense in specified situations
- is not considered to be a payment made in respect of the acquisition by the payer or a public authority of an interest in the taxpayer or the taxpayer's business or property
Paragraph 12(1)(x) applies to amounts (other than a prescribed amount) received by a taxpayer in the course of earning income from business or property from a person or partnership, a government, municipality, or other public authority. A person or partnership who pays the particular amount (the payer) must do so in the course of earning income from a business or property, or to achieve a benefit or advantage for the payer or for persons with whom the payer does not deal at arm's length, or it is reasonable to conclude that the payer would not have paid the amount but for the receipt by the payer of amounts from a payer, government, municipality or public authority.
Subparagraphs 12(1)(x)(v) to (viii) specify what amounts may be excepted from an inclusion in income pursuant to paragraph 12(1)(x):
- An amount that was not otherwise included in computing the taxpayer's income, or deducted in computing any balance of undeducted outlays, expenses or other amounts, for the year or a preceding tax year. (An example of a balance of undeducted outlays is the pool of expenditures in respect of scientific research and experimental development established under section 37. In such a case, the assistance received is not included in income by virtue of paragraph 12(1)(x), to the extent that it has reduced the pool.)
- Except as provided by subsection 127(11.1), (11.5) or (11.6), an amount that has reduced the cost of property or the amount of an outlay or expense.
- An amount subject to an elective provision (subsection 12(2.2) or 13(7.4) or paragraph 53(2)(s)) that reduces the cost of property or an outlay or expense instead of including the amount in income under paragraph 12(1)(x).
- A payment in respect of the acquisition by the payer or public authority of an interest in the taxpayer or the taxpayer's business or property (for example, government assistance offered to a corporation in the form of a purchase of shares from the share capital of the corporation).
For the definition of prescribed amount for purposes of paragraph 12(1)(x), go to section 7300 of the Income Tax Regulations. Prescribed amount means prescribed assistance within the meaning assigned by section 6702 of the Regulations.
A deduction is available under paragraph 20(1)(hh) of the ITA regarding the repayment of government assistance that was previously included in income under paragraph 12(1)(x), provided that the taxpayer is under a legal obligation to repay such amount. It also provides for a deduction of the repayment (again, pursuant to a legal obligation to repay) of certain other inducements or assistance that were not included in the taxpayer's income under paragraph 12(1)(x), but instead reduced the amount of outlays and expenses that would have been deductible by the taxpayer.
Under subsection 248(16) of the ITA, amounts claimed by a taxpayer as an input tax credit (ITC) or rebate with respect to the GST are deemed to be assistance from a government received by the taxpayer. Consequently, such amounts are either included in income or reduce the cost or capital cost of the related property, or the amount of the related expenditure or expenditure pool for tax purposes. The provision also specifies the time at which the receipt (or credit) of an ITC or rebate is deemed to be received as assistance.
Therefore, for example, the amount of any ITC or rebate which is deemed to be received by a taxpayer:
- is included in income under paragraph 12(1)(x) to the extent that it relates to GST/HST paid for an outlay or expense, unless the expense was already reduced by the ITC
- reduces the capital cost of depreciable property under subsection 13(7.1) to the extent that it relates to GST/HST paid for such property
- reduces the adjusted cost base (ACB) of non-depreciable capital property under paragraph 53(2)(k) to the extent that it relates to GST/HST paid for such property
Subsection 13(7.1), provides that the capital cost of a depreciable property is reduced by the amount of investment tax credits deducted by the taxpayer under subsection 127(5) or (6) and by the amount of certain other government assistance received or that the taxpayer is entitled to receive in respect of a depreciable property.
The reduction in the capital cost of depreciable property resulting from the application of subsection 13(7.1) applies for the purposes of calculating any recapture, terminal loss, and capital gain on the eventual disposition of the property, with the result that it is the adjusted capital cost under subsection 13(7.1) which is utilized.
The tax treatment of repayments of assistance received in respect of depreciable property depends on whether the taxpayer still owns the property at the time the assistance is repaid. When the taxpayer still owns the property and repays all or part of the assistance pursuant to a legal obligation to do so, the amount repaid increases the capital cost of the property under paragraph 13(7.1)(d) (or paragraph 13(7.1)(b) in those cases where the taxpayer has made a subsection 13(7.4) election). A repayment which is made after the related depreciable property has been disposed of, increases the undepreciated capital cost (UCC) of the relevant class of depreciable property, provided that the taxpayer is under a legal obligation to repay that amount.
Paragraph 53(2)(k) of the ITA provides for a reduction of the adjusted cost base (ACB) of a capital property that is not a depreciable property, by the amount of government assistance that the taxpayer received or is entitled to receive in relation to that property, with the exception of certain specified amounts.
The repayment of assistance received in respect of a capital property (other than depreciable property), under a legal obligation to do so, decreases the amount of the reduction of the ACB of the property pursuant to paragraph 53(2)(k), (or subparagraph 53(2)(s)(ii) where the taxpayer has made an election under subsection 53(2.1)). In effect, the ACB of the property is increased by virtue of the repayment. If the property is disposed of before the assistance is repaid, there is no provision to adjust the capital gain or loss previously realized on the disposition of that property; however, the amount of the repayment is deemed to be a capital loss under subsection 39(13).
Subsection 13(7.4) of the ITA allows a taxpayer to make an election whereby the capital cost of a depreciable property is reduced by the amount of assistance that would otherwise be included in the taxpayer's income by virtue of paragraph 12(1)(x).
Subsection 12(2.2) of the ITA provides that a taxpayer may elect to reduce the amount of an outlay or expense (other than an outlay or expense in respect of the cost of property) where assistance, which would otherwise be included in income under paragraph 12(1)(x), is received in respect of the outlay or expense. This subsection applies only in those cases where the set-off of an expense or outlay against a related receipt does not otherwise result under the ITA. The provision was introduced in order to allow GST credits and rebates to be treated as reductions in expenses rather than include them in income. The terms of this provision are broad enough to apply to situations other than the GST.
Subsection 53(2.1) of the ITA permits a taxpayer to elect to reduce the adjusted cost base (ACB) of a non-depreciable property acquired by the taxpayer in the year the assistance was received, in the three tax years preceding the year or in the tax year following the year, where the assistance would otherwise be included in the taxpayer's income under paragraph 12(1)(x). The amount elected under subsection 53(2.1) reduces the taxpayer's ACB under paragraph 53(2)(s). Paragraph 53(2)(s) provides for a reversal of the cost base reduction (that is, an increase to the ACB) to the extent the assistance is repaid by the taxpayer pursuant to a legal obligation to do so.
The elected amount cannot be greater than the least of:
- the ACB at the time the property was acquired
- the amount of the assistance received, and
- nil, in cases where the taxpayer disposed of the property before the year in which the assistance is received
A Ltd. (the payer) has operated a shopping centre for several years and was finally able to attract B Ltd., a major chain store, as a tenant. The following are the terms of the lease agreement, as proposed and accepted:
- a payment of $12,000 made to B Ltd. at the end of the first year of the lease, as a refund of part of the monthly rent paid
- a reimbursement payment of $15,000 by the payer of part of the leasehold improvements made by B Ltd.
- a payment of $10,000 made to B Ltd. on signing the lease
These payments were made during a single fiscal year of the tenant.
B Ltd. must include in its income from a business, in the year they were received, the following amounts:
- the amount of $15,000, which represents a reimbursement in respect of the cost of the leasehold improvements (subparagraph 12(1)(x)(iv))
- the amount of $10,000, which represents an inducement payment with respect to the signing of the lease (subparagraph 12(1)(x)(iii))
The amount of $12,000 will also be included in income (subparagraph 12(1)(x)(iv)), unless it was already used to reduce the rental expense otherwise claimed (subparagraph 12(1)(x)(vi)).
Although the amount received as an inducement payment by the recipient may be on account of capital, this does not necessarily mean that it is an outlay of the same nature for the payer. The tax treatment of a transaction involving an inducement payment must be examined for each party involved in the particular transaction, taking into account the following factors:
- provisions of the ITA and applicable legal precedents
- commercial and business principles governing the transaction (including GAAP)
- agreement between the parties to the transaction
- framework of the legislation under which the assistance is provided and the conditions of eligibility for the payment
- nature of the payment
- nature of the business carried on by each party
The tax treatment of an inducement payment for the recipient and the payer may, therefore, be different or similar, depending on the situation and the facts specific to each case and to each party.
As mentioned previously, an inducement payment can come from government, private, and other public authorities and can take various forms. In general, its tax treatment will vary depending on whether it is received on account of income (payment made to increase the taxpayer's income or to reimburse operating costs) or on account of capital (assistance to acquire a capital property).
Lease inducement payments
The Supreme Court of Canada allowed the taxpayers' appeals in Toronto College Park Ltd v The Queen, 98 DTC 6088, and Canderel Ltd v The Queen, 98 DTC 6100. The issue was if lease inducement payments made to induce tenants to enter into leases were fully deductible in the year incurred or had to be deducted over the term of the respective leases (go to 27.9.8 for an overview of the Canderel case).
The CRA argued that the inducement payments should be deducted over the terms of the leases. This was based on well-accepted business principles that expenditures which give rise to future revenues should be amortized and deducted against those revenues (the matching principle).
The Court found that the payments of the inducements did not only result in a stream of revenue over the terms of the leases, but also resulted in other benefits to the taxpayer, some of which were realized in the year the expenditures were incurred, including lower financing costs and enhanced reputation. Therefore, the taxpayers could fully deduct the inducements in the year incurred.
After the decisions handed down by the Court, the Income Tax Appeals Directorate stated in Decision 95-32R2 that a taxpayer may be entitled to fully deduct lease inducement payments in the year incurred, if the following three conditions are met:
- The payments cannot be viewed as having been principally incurred for the specific purpose of earning a discrete and identifiable item of future revenue.
- Current deductibility of the payments is permissible under GAAP or any other well-accepted business principle, and this gives the most accurate picture of the profit.
- No portion of the payments is on capital account, such as giving rise to an eligible capital expenditure.
For more information, refer to Appeals Branch Income Tax Decision 95-32R.
Ikea Ltd v The Queen, 1998 (SCC), 98 DTC 6092
The Supreme Court of Canada dismissed the appeal of Ikea Ltd. The inducement payment received by the appellant to sign a lease was taxable as income. The entire amount had to be included in income in the year the lease was signed, based on the realization principle, since it had been made with no condition or stipulation attached as to its use. This case was decided before the introduction of paragraph 12(1)(x).
Canderel Ltd v The Queen, 1998 (SCC), 98 DTC 6100
The Supreme Court of Canada, which had previously denied the taxpayer' leave application, allowed its appeal.
This case dealt with lease inducement payments, which the appellant had treated as running expenses deductible in the year they were incurred, while the CRA argued that these payments should be deducted over the term of the leases according to the matching principle. It should be noted that the
CRA did not consider these inducement payments as expenditures of a capital nature. The question was, therefore, to determine whether the inducement payments, made to get the tenants to sign leases, were fully deductible in the year they were incurred or whether they should be amortized over the term of the leases.
The Court ruled in Canderel, that the method of computation of income adopted by the taxpayer was not inconsistent with any rule of law. It was determined that the lease inducement payments could not be matched primarily with any particular item of income. Since these payments were allowable as running expenses to which the matching principle does not apply, they could be deducted in full in the year in which they were made and it was not necessary to amortize these payments over the term of the leases signed as a result of these payments.
For more commentary about the Ikea and Canderel court decisions, go to Income Tax Technical News, cancelled Issue No. 16, published by the Policy and Planning Branch.
Other court cases relating to inducement payments
Income tax cases
Trans Canada Glass Ltd v MNR - 93 DTC 1260
The lease inducement payment received by a taxpayer in the auto glass business upon leasing premises for use as a new head office was included in its income, considering that such payment could not be connected with any capital purpose and was directly and inextricably bound up with the economics of the taxpayer's operation.
Canada Safeway Ltd v The Queen - 97 DTC 187
The refund that the taxpayer received in 1994 of the federal sales tax paid and deducted by its predecessors between 1985 and 1989 had to be brought into its income for the years in which it was originally deducted rather than in its 1994 income. The ITA was amended to include "refunds" in subparagraph 12(1)(x)(iv) after the Federal Court of Appeal upheld the Tax Court of Canada's decision in this case.
Tioxide Canada Inc v The Queen - 96 DTC 6296
A tax credit received by the taxpayer under section 1029.7 of the Quebec Taxation Act was an inducement payment for the purposes of paragraph 12(1)(x) of the ITA.
IBM Canada Ltd v MNR - 93 DTC 1266
When a computer-manufacturing corporation received lease inducement payments from different landlords with respect to seven leases, such payments were included in income. In this case, the primary consideration granted by the taxpayer was its acceptance of its obligations under the various leases to pay rent, and these obligations were on revenue account. The inducement payments were just as much revenue payments, as were the periodic rental payments to the landlords.
Supermarché Ste-Croix Inc v The Queen - 97 DTC 5211
The corporate taxpayer operated a grocery supermarket. It entered into an agreement under which it became obligated to obtain 90% of its supplies from M Inc. Under this agreement, M Inc. was also given a first option to acquire the taxpayer's business should the taxpayer ever decide to sell it.
In assessing the taxpayer, the minister included in its income, as an inducement payment, the $150,000 cash sum paid to it by M Inc. upon entering into the agreement.
After the Tax Court of Canada confirmed the assessment, the taxpayer appealed to the Federal Court of Appeal and the appeal was dismissed. The payment gave M Inc. no direct interest in the taxpayer's business and no pecuniary right to share any of its profits. The payment, therefore, had to be included in the taxpayer's income.
Woodward Stores Ltd v The Queen - 91 DTC 5090
The taxpayer received payments (fixture allowances) intended to induce it to enter into two long-term leases in two shopping centres. The payments at issue were capital-related inducement payments as opposed to a windfall.
Quincaillerie Laberge Inc c La Reine - 95 DTC 47
When a taxpayer had agreed to waive its right to collect $10.5 million under a "giving in payment" clause allowing the taxpayer to take immediate possession of the debtor's property upon default, in consideration for the sum of $575,000, that amount constituted a taxable inducement payment within the meaning of paragraph 12(1)(x) of the ITA.
Suzy Creamcheese (Canada) Ltd v The Queen - 92 DTC 6291
The leasehold inducement payments received by the taxpayer had been applied in accordance with GAAP to reduce the total capital expenditures made by it on its leasehold improvements. Therefore, such payments had been earmarked for capital purposes and were capital in nature.
Income Tax Interpretation Bulletins
Work in progress of a professional business
The ITA provides special rules for computing the income of taxpayers carrying on designated professional businesses. Under section 34 of the ITA, taxpayers are permitted to elect to exclude, in computing the income from such a business, the amount of work in progress at the end of the year. A designated professional business includes the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian, or chiropractor. The taxpayer may be a corporation or an individual practicing alone or as a member of a partnership. Once a taxpayer has made an election, work in progress of that business may not be included in income for subsequent years, unless the election is revoked with the concurrence of the minister.
If a taxpayer is a member of a partnership, under subsection 96(3), provides that an election to exclude work in progress can be made only by the partnership; that is, the election must be executed on behalf of all the partners by one partner authorized to act for the partnership. Once this has been done, all the other partners are deemed to have made a valid election and are bound by it.
For more information about the election, go to Income Tax Interpretation Bulletin IT457R, Election by professionals to exclude work in progress from income.
Since the term work in progress is not defined in the ITA, it is given the meaning commonly used in business, which is partly finished goods or services in the process of completion, but for which an amount has not become receivable.
Work in progress must be included in computing a taxpayer's income if a section 34 election is not in force. Since the work in progress of a business that is a profession is considered inventory under paragraph 10(5)(a), the amount to be included is based on allowable inventory valuation principles found in section 10 of the ITA.
For more information, go to Income Tax Interpretation Bulletin IT473R, Inventory Valuation.
Recognition of income
Paragraph 12(1)(b) of the ITA requires any amount receivable in respect of a property sold or services rendered in the course of a business (including a professional business) in a year to be included in that year's income. An amount is deemed to become receivable on the day the account is rendered or would have been rendered had there been no undue delay, whichever is the earlier.
In addition, under subparagraph 12(1)(a)(i), a taxpayer is required to include in income any amount that is received in a tax year on account of services not rendered or goods not delivered before the end of the year or that for any other reason, may be regarded as not having been earned in the year or prior year. If the taxpayer includes such an amount in income, paragraph 20(1)(m) allows a deferment of tax on such unearned income by allowing a taxpayer to deduct a reasonable reserve in respect of services that will have to be provided after the end of the year. In accordance with paragraph 12(1)(e), any amount deducted as a reserve is included in computing the taxpayer's income for the immediately following tax year.
For more information about reserves, go to Income Tax Interpretation Bulletin IT154R, Special reserves.
The meaning of fiscal period is found in subsection 249.1(1) of the ITA. For fiscal periods beginning after 1994, all sole proprietorships, professional corporations that are members of a partnership, and partnerships (if at least one member of the partnership is an individual, professional corporation, or another affected partnership) must have a December 31 fiscal year end. However, subsection 249.1(4) allows individuals and partnerships (all the members of which are individuals), on a business-by-business basis, to elect to retain a non-calendar fiscal period (alternative method).
Section 34.1 provides the rules for computing the additional business income of taxpayers who elect under subsection 249.1(4) to have an off-calendar fiscal period. These taxpayers are required to adjust their income from the business to a calendar year basis for income tax purposes.
If a taxpayer has elected to have a non-calendar fiscal year with respect to a business, to calculate the income from the business for each year:
Business income based on off-calendar fiscal period
Add: Additional income inclusion for the current tax year
Less: Additional income inclusion for the previous tax year
Equals: Business income for tax purposes
Including the additional income inclusion each tax year is a formula-based estimate of the business income earned between the end of the fiscal period and December 31 of the year.
Individuals and eligible partnerships that adopt the alternative method are permitted to change to a December 31 fiscal year end. However, once the change is made, they are not allowed to change to an off-calendar fiscal year-end.
For more information about the fiscal period rules, go to Form T1139, Reconciliation of Business Income for Tax Purposes.
When auditing taxpayers who elect to maintain a non-calendar fiscal period, auditors must determine the following:
- Whether taxpayers who elect to retain a non-calendar fiscal period have correctly calculated their business income for the tax year, in particular the additional business income amount
- Auditors must also make sure that the deduction in the current year, of the prior year additional business income amount, is correct
The taxpayer elects to maintain a non-calendar (January 31) fiscal year-end (FYE).
(Subsection 249.1(4) and section 34.1)
Tax year 20X5 20X6 20X7
Income FYE Jan. 31 $100,000 $140,000 $130,000
Add: Additional business
income (Feb. 1 to Dec. 31)
20X5 - 334/365 of $100,000 91,507
20X6* - 335/366 of $140,000 128,142
20X7 - 334/365 of $130,000 118,959
Deduct: Additional business
income (Previous year) n/a 91,507 128,142
Net business income $191,507 $176,635 $120,817
Income Tax Act
- Subsection 10(5) - Inventory
- Subparagraph 12(1)(a)(i) - Services to be rendered
- Paragraph 12(1)(b) - Amounts receivable
- Paragraph 12(1)(e) - Reserves for certain goods and services
- Paragraph 20(1)(m) - Reserve in respect of certain goods and services
- Section 34 - Professional business
- Section 34.1 - Additional business income
- Section 34.2 - Reserve for December 31, 1995 income
- Section 249.1 - Definition of fiscal period
- Subsection 249.1(4) - Alternative method
Income Tax Interpretation Bulletins
- IT154R, Special reserves
- IT457R, Election by professionals to exclude work in progress from income
- IT473R, Inventory Valuation
Income Tax Rulings
- 9821147(E), September 9, 1998, LCT and Partnerships
- 9805547(E), May 19, 1998, Forgiven Amount
- 9731937(E), July 3, 1998, Fiscal Periods - Bankrupt Individual
- 9616125(E), June 17, 1996, Reserve - Qualifying Fiscal Period
- 9610575(E), September 11, 1996, Fiscal Period - Co-Ownership
- 9606175(E), October 22, 1996, Fiscal Period of Partnership
- 9530795(E), March 7, 1996, 10-Year Reserve - Fiscal Period
The term Social assistance payment is not defined in the ITA. Social assistance or social security is defined in the dictionary as a system whereby which the state provides financial assistance to those citizens whose income is inadequate or non-existent due to disability, unemployment, old age, etc. A social assistance payment is usually made on the basis of a means, needs, or income test under a program provided for by an act of Parliament or a law of a province and is not dependent on the recipient engaging in a particular type of activity.
Social assistance are payments made to beneficiaries or third parties based on a means, needs, or income test and include payments for food, clothing, and shelter requirements to:
- impaired individuals, whether in nursing homes or similar accommodations or in self-sustained dwellings
- elderly individuals (over 64 years of age), whether or not they live in nursing homes or similar accommodations
These amounts can also include actual rental or mortgage amounts paid for accommodation.
As a general rule, social assistance payments are included in computing net income under paragraph 56(1)(u) of the ITA and an equivalent deduction is provided under paragraph 110(1)(f) in computing taxable income. The purpose of this system is to make sure that social assistance payments are not subject to income tax, but are taken into account in determining the amount of certain refundable and non-refundable tax credits, such as the Canada child benefit and the age amount. If the taxpayer lived with their spouse or common-law partner at the time either of them received social assistance payments, the individual with the higher net income must report the payments.
Section 81 of the ITA lists various amounts that are not included in computing a taxpayer's income for a tax year. Paragraph 81(1)(h) specifically exempts certain social assistance payments. This includes payments to individual caregivers for the benefit of foster persons (children or adults) under care. The following are the conditions that must be met for payments to qualify for exemption:
- The foster person must reside in the caregiver's principal place of residence or the caregiver's principal place of residence is maintained for use as the residence of the foster person.
- The payment must constitute social assistance that is ordinarily made on the basis of a means, needs, or income test under a program provided for by federal, provincial, or territorial legislation.
- The amount must be received, directly or indirectly, by the taxpayer (caregiver) for the benefit of the foster person.
- The exemption does not apply if the foster person is the caregiver's spouse or common-law partner or if the foster person is related to the caregiver or to the caregiver's spouse or common-law partner.
- No family allowance under the Family Allowances Act, or any similar allowance provided for by provincial or territorial law, is payable in respect of the foster person for the period for which the social assistance payment is made to a foster-care provider.
There is particular concern with the exempting provision in paragraph 81(1)(h) that states the payment may be received "directly or indirectly" by the caregiver for the benefit of the cared for individual. The underlying tax policy is that the end caregiver would not be subject to income tax.
The CRA has reviewed payment methods used by provincial authorities to establish which methods meet the requirements for income tax exemption. Methods allowed include payments made:
- directly to a caregiver by a provincial government
- to a caregiver through a provincially funded non-profit organization, such as a local children's aid society
- to a caregiver through a taxable corporation that receives the funds from the provincial government
The exemption will also apply in the above situations if the caregiver is an employee of one of these organizations. However, it is necessary to make sure that all of the other conditions for the application of paragraph 81(1)(h) are met.
It is CRA's position that foster care payments can be flowed through a taxable (for-profit) entity and remain tax-exempt. Note that there is no distinction made in the law for a social assistance payment made to a taxpayer by a for-profit entity or a not-for-profit entity. Accordingly, if the requirements of the exempting provision are otherwise met, then the foster care payments flowing through a taxable entity will have the same tax-free treatment as payments made through non-profit entities.
For more information about the application of paragraph 81(1)(h), go to Income Tax Technical News:
- cancelled Issue No. 17, April 26, 1999
- Issue No. 31R2, May 16, 2006
Section 233 of the Income Tax Regulations requires every person who pays an amount for social assistance payments to file an information return reporting those payments. This is done using the T5007 information return, consisting of:
Any provincial, territorial, municipal agency, or similar person that makes social assistance payments based on a means, needs, or income test must file the information return. This mandatory reporting is intended to facilitate administering the Act with respect to entitlement of a taxpayer or a person supporting the taxpayer to refundable and non-refundable tax credits.
These social assistance amounts do not have to be reported on the T5007 information return:
- a payment that is made in a year as part of a series of payments totalling $500 or less in the tax year
- a payment that is not part of a series of payments
- medical expenses incurred by or for the payee
- child-care expenses that otherwise qualify for a deduction under section 63 of the ITA
- funeral expenses for a person related to the payee
- legal expenses incurred by or for the payee or a person related to the payee
- job training or counselling for the payee or a person related to the payee
The wording of subsection 233(1) of the Regulations encompasses all payments described in paragraph 56(1)(u), whether they are included in income under that paragraph or excluded under paragraph 81(1)(h). Consequently, T5007 slips must be filed for social assistance payments even if the payments are excluded from income by virtue of paragraph 81(1)(h).
For more information about the reporting requirements, go to Tax Guide T4115, T5007 Guide - Return of Benefits.
Income Tax Act
- Paragraph 56(1)(u) - Social assistance payments
- Paragraph 81(1)(h) - Social assistance
- Paragraph 110(1)(f) - Deductions for payments
Income Tax Regulations
- Section 233 - Social assistance
Income Tax Rulings
- 2001-0075425, June 13, 2001, Social Assistance Payments
- 2001-0071295, April 5, 2001, Social Assistance
- 2000-0009086, April 11, 2000, Social Assistance
- 9932686, December 20, 1999, Social Assistance Payments
- Tax Guide T4115 T5007 Guide - Return of Benefits
- Income Tax Technical News, cancelled Issue No.17, April 26, 1999
- Income Tax Technical News, Issue No. 31R2, May 16, 2006
Paragraph 18(1)(a) of the ITA limits outlays or expenses to the extent that they were incurred to generate revenue. Section 67 takes this further to say that even if they were used to generate revenue, only that portion that is reasonable is allowed as a deduction. This section is often used to disallow excess amounts in non-arm's length transactions. But what happens to the recipient of the unreasonable amount?
If the payer is an individual:
If the recipient received the amount in the course of employment, subsection 5(1) says it must be included in income. There is no section to indicate that they should only include the portion that was reasonable. When dealing with non-arm's length transactions, especially if the employees are family members, whether an amount is received is a question of fact to be determined by the auditor.
A dentist's eight-year old child is paid $15,000 a year for three hours of filing each Saturday. Based on other employees in the office, the auditor determines that approximately $15 an hour is reasonable and disallows $12,600. The dentist claims that the entire salary amount was paid to a private school as the child's tuition.
A consultant's spouse is paid $60,000 a year for accounting and "management" advice, although the spouse has no expertise in the consultant's field. The auditor disallows $40,000 under section 67, but all $60,000 has been deposited into a joint account under both spouses' names.
In each case, it is a question of fact whether the employee has received the money and must report it as employment income. If it has not been received, the employee is not required to include the amount as income.
If the recipient reported the amount in the course of business (self-employed), subsection 9(1) and paragraphs 12(1)(a) and (b) normally work to make sure the amounts are included in income. Again, it is a question of fact as to whether the amount has been earned, has been received, or is receivable.
If the payer is a corporation:
If the payer is a corporation, another issue to consider is whether any amount disallowed by section 67 was still part of a bona fide business transaction, or was this excess amount a benefit that the corporation or shareholder wanted to confer? This will be a question of fact for the auditor to determine and it may be possible that subsections 15(1) (benefit to shareholder), 56(2) (indirect payments), or 246(1) (benefits conferred) will apply.
For more information on the application of these subsections, go to 24.0, Transactions involving related persons, corporations and shareholders, dividends, etc.
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