Income Tax Audit Manual

Compliance Programs Branch (CPB)

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Chapter 29 Losses

• 29.1.0 Non-capital losses
• 29.2.0 Capital losses
  • 29.2.1 Loss and capital loss defined
  • 29.2.2 Allowable capital loss
  • 29.2.3 Capital losses from dispositions of personal-use property/listed personal property
  • 29.2.4 Specific exceptions to capital gain and loss rules
• 29.3.0 Business investment losses
  • 29.3.1 Overview - Business investment loss
  • 29.3.2 Deemed dispositions under subsection 50(1)
  • 29.3.3 Small business corporation
  • 29.3.4 Bad debts
  • 29.3.5 Debts from a guarantee
  • 29.3.6 Allowable business investment loss
  • 29.3.7 Audit issues – Allowable business investment loss
  • 29.3.8 References
  • 29.3.9 Questionnaire for Allowable Business Investment Losses
  • 29.3.10 Audit steps – Allowable business investment loss claims
• 29.4.0 Farm losses and restricted farm losses
  • 29.4.1 Overview
  • 29.4.2 Farming defined
  • 29.4.3 Farming as a business
  • 29.4.4 Inventory adjustments: Farm income computed using the cash method of accounting
  • 29.4.5 Farm losses not deductible - No source of income
  • 29.4.6 Chief source of income
  • 29.4.7 Restricted farm losses
  • 29.4.8 Audit procedures to determine chief source of income
  • 29.4.9 Example - Compute an allowable farm loss and a restricted farm loss
  • 29.4.10 Farm losses - References
  • 29.4.11 Schedule A: Summary of taxpayer's income and composition of farm loss
• 29.5.0 Loss carryovers
  • 29.5.1 Application of losses
  • 29.5.2 Carryover of non-capital losses
  • 29.5.3 Carryover of listed personal property losses
  • 29.5.4 Carryover of farm losses
  • 29.5.5 Carryover of limited partnership losses
  • 29.5.6 Carryover of allowable business investment losses
  • 29.5.7 Carryover of net capital losses
  • 29.5.8 Other considerations
  • 29.5.9 Audit issues - loss carryovers
  • 29.5.10 Loss carryback administrative procedures
  • 29.5.11 References

29.0 Losses

29.1.0 Non-capital losses

A non-capital loss, in very general terms, includes any loss incurred from employment, property or a business incurred in a year to the extent that they cannot be used to offset income from other sources in the loss year. To the extent that an allowable business investment loss (ABIL) realized in a year cannot be used to offset other income, it is also included as a non-capital loss.

Note that the taxpayer's non-capital loss for the year can include the unused portion of the taxpayer's share of partnership losses from business or property, or partnership ABILs (go to 29.3.0, Business investment losses). However, it cannot include a "limited partnership loss" or a "restricted farm loss," and may be subject to certain adjustments.

The taxpayer's non-capital loss for the loss year can be carried back 3 years and forward 20 years to offset income for those years. Note that an unused ABIL is only a non-capital loss for 10 years (see paragraph (c) in the definition of “E” in the non-capital loss definition at subsection 111(8)), and then reverts to a capital loss.

29.2.0 Capital losses

29.2.1 Loss and capital loss defined

As defined in paragraph 40(1)(a) of the ITA, a “taxpayer's gain for a taxation year from the disposition of any property is the amount” by which the proceeds of disposition (POD) for that property exceed the total of the adjusted cost base (ACB) of the property and all "outlays and expenses" incurred in disposing of the property, such as legal fees and realtor commissions.

Conversely, a “taxpayer's loss for a taxation year from the disposition of any property,” pursuant to paragraph 40(1)(b), is the amount by which the ACB plus the outlays and expenses exceed the POD.

The ITA relies on section 54 for the definition of “capital property” and it includes:

• a depreciable property;
• any property where the gain or loss on disposition is a capital gain or capital loss.

Subsection 248(1) defines “property” to include anything from money, to work in progress, to shares. And then paragraphs 39(1)(a) and (b) indicate that a capital gain or loss is a gain or loss from the disposition of property not otherwise included because of section 3 (without including parts of section 3 and with some exclusions listed below).

Paragraph 3(a), in general terms, says that “income” includes income from an office, employment, business, and property. Paragraph 3(d) says something similar for losses.

It is then a question of fact of whether a disposition is on account of income (in which case, it is generally included by section 3) or is on account of capital.

Justice Rouleau, in his ruling in Happy Valley Farms Ltd v the Queen, [1986] 2 CTC 259, provided a non-exhaustive list of six tests that have been used by the courts to help determine if a transaction is on account of income or capital.

• The nature of the property sold. Although virtually any form of property may be acquired to be dealt in, those forms of property, such as manufactured articles, which are generally the subject of trading only are rarely the subject of investment. Property which does not yield to its owner an income or personal enjoyment simply by virtue of its ownership is more likely to have been acquired for the purpose of sale than property that does.
• The length of period of ownership. Generally, property meant to be dealt in is realized within a short time after acquisition. Nevertheless, there are many exceptions to this general rule.
• The frequency or number of other similar transactions by the taxpayer. If the same sort of property has been sold in succession over a period of years or there are several sales at about the same date, a presumption arises that there has been dealing in respect of the property.
• Work expended on or in connection with the property realized. If effort is put into bringing the property into a more marketable condition during the ownership of the taxpayer or if special efforts are made to find or attract purchasers (such as the opening of an office or advertising) there is some evidence of dealing in the property.
• The circumstances that were responsible for the sale of the property. There may exist some explanation, such as a sudden emergency or an opportunity calling for ready money that will preclude a finding that the plan of dealing in the property was what caused the original purchase.
• Motive. The motive of the taxpayer is never irrelevant in any of these cases. The intention at the time of acquiring an asset as inferred from surrounding circumstances and direct evidence is one of the most important elements in determining whether a gain is of a capital or income nature.

A “taxpayer's capital loss” for a tax year, under paragraph 39(1)(b), is the taxpayer's loss computed in accordance with Division B, Subdivision c of the ITA (to the extent that the amount is not otherwise deductible for that year or for any other year) from the disposition of any property, other than:

• a property in the taxpayer's inventory, (included in non-capital loss);
• a depreciable property referred to in subparagraph 39(1)(b)(i);
• an eligible capital property referred to in subparagraph 39(1)(a)(i);
• a Canadian resource property referred to in subparagraph 39(1)(a)(ii);
• a foreign resource property referred to in subparagraph 39(1)(a)(ii.1);
• a specified debt obligation, to the disposition of which subsection 142.4(4) or (5) applies or a property that is a mark-to-market property, to the disposition of which subsection 142.5(1) applies, referred to in subparagraph 39(1)(a)(ii.2);
• an insurance policy referred to in subparagraph 39(1)(a)(iii); or
• an interest of a beneficiary under an environmental trust referred to in subparagraph 39(1)(a)(v).

29.2.2 Allowable capital loss

A taxpayer's allowable capital loss from the disposition of any property is simply 1/2 the capital loss after October 17, 2000, and subsequent tax years.

The allowable capital loss must be calculated using the actual inclusion rates outstanding in the period. Therefore, you may need to prorate in periods where the rates change. If the taxpayer had gains and losses in more than one period during 2000, go to Tax Guide T4037, Capital Gains, for the special rules to determine the inclusion rate.

Taxpayers with a non-calendar year-end (some corporations) are treated similar to individuals; they must report capital gains and losses separately, subject to varying inclusion rates.

In computing the taxpayer's income, in accordance with paragraph 3(b) of the ITA, the taxpayer's allowable capital losses for the year from dispositions of property are deducted from the taxpayer's taxable capital gains for the year. If the allowable capital losses exceed taxable capital gains for the year, the excess amount is the taxpayer's net capital loss for the year. It can be carried back three years and forward indefinitely and deducted in computing the taxpayer's taxable income in those years, but only to the extent of any taxable capital gains included in the taxpayer's income for the year.

29.2.3 Capital losses from dispositions of personal-use property/listed personal property

Personal-use property (PUP), as defined in section 54 of the ITA, includes any property owned by a taxpayer primarily for that or a related person's personal use or enjoyment. It also includes partnership property owned primarily for the personal use or enjoyment of one or more members of the partnership or persons related thereto as well as an option to acquire property that would be, if acquired, PUP.

Subparagraph 40(2)(g)(iii) deems a loss on the disposition of a PUP, other than listed personal property (LPP), to be nil. Since any gains or losses are calculated on a property-by-property basis, a loss on one PUP cannot offset a gain on another PUP.

LPP is a subset of PUP and includes paintings, sculptures, stamp and coin sets, and jewellery. Losses on dispositions of LPP are first applied to reduce gains on dispositions of LPP arising in the same tax year. Any resulting net loss may be carried back against net LPP gains of the three previous tax years and carried forward against such gains of the subsequent seven tax years (paragraph 41(2)(b)).

Subsection 46(1) sets out how to calculate any gain or loss on the disposition of PUP. The subsection discusses the "$1,000 rule." As stated, on disposition of PUP, if either the ACB or the POD is less than $1,000, then the ACB or POD is deemed to be $1,000. Therefore, for purposes of recognizing a loss, a loss is only reported if the ACB is more than $1,000. However, as already stated, any loss is deemed to be nil, unless it is LPP.

29.2.4 Specific exceptions to capital gain and loss rules

Superficial losses

As discussed in section 54 of the ITA, there is a superficial loss if the same or an identical property (a “substituted property”) is acquired in the period 30 days before or after a disposition by a taxpayer or an affiliated person, and at the end of the 60-day period the taxpayer or the affiliated person owns or had a right to acquire the substituted property; subparagraph 40(2)(g)(i) of the ITA deems the capital loss to be nil.

For more information, go to Income Tax Interpretation Bulletin IT387R2-CONSOLID, Meaning of Identical Properties.

Loss from the disposition of a debt or other right

A loss from the disposition of a capital debt or other right to receive an amount is nil under subparagraph 40(2)(g)(ii), unless the debt or the right was acquired:

• for the purpose of gaining or producing income from a business or property, for example monies lent to a corporation at a reasonable rate; or
• as consideration for the disposition of capital property to a person with whom the taxpayer was dealing at arm's length.

Sometimes a taxpayer disposes of a capital property and cannot recover all or any portion of the proceeds, but the taxable capital gain is included in their income. In accordance with subsection 248(1) definition of "disposition", settlement or cancellation of a debt owing to a taxpayer, or of any other right a taxpayer has to receive an amount, is a disposition of property.

If the debt is considered uncollectible at the end of a tax year, the taxpayer may elect, in accordance with subsection 50(1), to be considered as having disposed of this debt for proceeds of nil and to have reacquired the debt at a cost of nil. The loss from the deemed disposition is a capital loss. However, any subsequent recovery of the debt is a capital gain.

Go to 29.3.0, Business investment losses, if the loss arises on the deemed disposition under subsection 50(1) of the debt or shares if the debt is shown to be bad or the corporation is bankrupt or insolvent.

For more information, the Canada Revenue Agency (CRA) continues to rely on the decision in The Queen v E. Byram, 1999 (FCA), 99 DTC 5117. 

For more information, go to Income Tax Interpretation Bulletin IT328R3, Losses on Shares on Which Dividends Have Been Received.

Disposition of capital property subject to warranty

Pursuant to section 42, if a taxpayer disposes of property subject to a warranty or other conditional or contingent obligation given or incurred by the taxpayer, the POD for the year include any amount received or receivable for the warranty. However, any expenditure the taxpayer must incur as a result of the warranty in the year of disposition or any subsequent year is deemed to constitute a loss from the disposition of property during the year it was incurred. For 1985 and subsequent tax years, take this deemed capital loss into account in determining a taxpayer's capital gains deduction under section 110.6 of the ITA.

References

Income Tax Interpretation Bulletins

• IT159R3, Capital debts established to be bad debts
• IT188R, Sale of accounts receivable
• IT188RSR, Special Release: Sale of Accounts Receivable
• IT328R3, Losses on Shares on Which Dividends Have Been Received
• IT387R2-CONSOLID, Meaning of Identical Properties

29.3.0 Business investment losses

29.3.1 Overview - Business investment loss

The business investment loss (BIL) rules in the ITA are intended to encourage investment in small business corporations (SBC) by offering more generous tax treatment on capital losses incurred on such investments than on ordinary capital losses. The BIL provisions allow a taxpayer to write-off directly against income from other sources, a portion of capital losses which relate to investments in an SBC. “Business investment loss” is defined under paragraph 39(1)(c) of the ITA.

As a general rule, a BIL is a capital loss from:

• a deemed disposition to which subsection 50(1) applies; or
• a disposition, to an arm's length purchaser of shares or debt of an SBC (defined in subsection 248(1)).

29.3.2 Deemed dispositions under subsection 50(1)

An ABIL includes a capital loss from "a disposition to which subsection 50(1) applies." Subsection 50(1) deems a disposition to have taken place if:

• a debt owing to a taxpayer at the end of a tax year has become a bad debt in the year; or
• the taxpayer owns a corporation’s shares at the end of a tax year, and the corporation is bankrupt or:
  • insolvent;
  • neither the corporation nor a corporation controlled by it carries on business;
  • the fair market value (FMV) of the share is nil; and
  • it is reasonable to expect that the corporation will be dissolved or wound-up and will not recommence business.

If the taxpayer elects under subsection 50(1) of the ITA for the debt or the shares, the debt or the shares are deemed to be disposed of for proceeds equal to nil and reacquired at the same nil cost.

For more information, go to Income Tax Folio S4-F8-C1, Business Investment Losses.

Reference

The issue decided in The Queen v E. Byram, 1999 (FCA), 99 DTC 5117, is whether a taxpayer can claim an allowable capital loss pursuant to subparagraph 40(2)(g)(ii) of the ITA for losses incurred on interest-free loans issued to a corporation for the purpose of earning dividend income.

29.3.3 Small business corporation

The definition of a “small business corporation” (SBC) under subsection 248(1) of the ITA specifically states in the post-amble that for the purpose of paragraph 39(1)(c), an SBC is a corporation that was an SBC at any time during the 12 months preceding the date of disposition of the shares or debt in question. This allows for BIL treatment of any loss if the corporation became inactive before the bankruptcy or disposition, as is often the case.

29.3.4 Bad debts

The taxpayer must claim a BIL for a bad debt in the year the debt is determined to be uncollectible. The taxpayer decides when a debt becomes a bad debt based on the facts after serious and reasonable analysis. It is not necessary for the debt to be absolutely unrecoverable, but there must be reason to believe it is a bad debt.

A debt is established to be a bad debt under paragraph 50(1)(a) of the ITA when the entire amount of the debt is unrecoverable, or when the debt has been settled in part and the remainder is unrecoverable. In general, a debt is deemed a bad debt when the taxpayer can establish one of these situations for the debt:

• All legal recourse to recover the debt has been exhausted.
• A corporate debtor is bankrupt, has abandoned its charter, or has been dissolved.
• While the taxpayer has not made every attempt to recover the debt, had the taxpayer done so, the debt would not have been recovered, and it would have resulted in the debtor's bankruptcy.
• There is good reason to believe the taxpayer cannot recover the debt; in general, audit evidence of the debtor's insolvency generally means a debt can be established to be a bad debt.

If the creditor is the debtor's main shareholder, recovery efforts are not required. However, the creditor must usually show that the corporation debtor has:

• permanently ceased to carry on business;
• insufficient assets to settle the shareholder's debt; or
• no expectation of a profit.

For more information in determining whether a debt is a bad debt, go to Income Tax Interpretation Bulletin:

• IT159R3, Capital debts established to be bad debts
• IT442R, Bad debts and reserves for doubtful debts

29.3.5 Debts from a guarantee

A debt may be incurred even after a corporation ceases to carry on business. As is often the case with the smaller private corporation, the principal shareholder may be a co-signer (guarantor) on all loans from the corporation's bank and other financial institutions that it deals with. However, a debt arising as result of such a guarantee can become a BIL if these conditions of subsection 39(12) of the ITA are met:

• The taxpayer pays an amount in respect of a debt of a corporation under the terms of a debt guarantee agreement.
• The taxpayer made the payment to a person with whom he was dealing at arm's length.
• The corporation was an SBC:
  • at the time the debt was incurred, for the purpose of a guarantee, the original date at which the guaranteed loan was granted; and
  • at any time during the 12 months before the time an amount first became payable under the guarantee agreement, the date the guarantee was called by the creditor.

A debt guarantee agreement is an official loan guarantee given to a lending institution. Payments made to third parties, such as public utilities, without a guarantee agreement are not subject to subsection 39(12).

To be an eligible capital loss, the guarantee, deemed to be a debt under subsection 39(12), must have been given for the purpose of producing income or for reasonable consideration. “Consideration” in this context refers to the fee charged by the guarantor for guaranteeing the corporate debt.

A guarantee given by a shareholder is usually considered to be given for the purpose of producing income regardless of separate consideration, if any. A guarantee given by a non-shareholder without consideration, or for other than reasonable consideration, may not be considered a capital loss. For more information, go to Income Tax Folio S4-F8-C1, Business Investment Losses (paragraphs 1.41 – 1.48).

The guarantee is paid when payments are made on behalf of the corporation. If the guarantor makes regular payments for the corporation's loan, the amounts and any interest paid are considered amounts paid during the year. When the guarantor pays the guaranteed loan in its entirety by taking out a loan, the amount is considered paid in full the year it was paid.

Interest payments on the loan are deductible under sections 20 and 20.1 of the ITA if:

• the corporation, whose debts were guaranteed, used the borrowed funds to produce income from business or property, or used the borrowed funds to lend money to its Canadian subsidiary in turn to be used to produce income from business or property; and
• the corporation could not obtain the necessary funds without the guarantee of the shareholder at interest rates at which the shareholder could borrow.

29.3.6 Allowable business investment loss

Compute allowable business investment loss

An ABIL, as computed under paragraph 38(c) of the ITA, is simply a portion of the taxpayer's BIL and is deductible in computing the taxpayer's income for the year under section 3 of the ITA. Generally, any excess ABIL that can't be deducted in the year, is treated as a non-capital loss. Non-capital losses may be carried back 3 years and carried forward for 20 years under 111(1)(a) and deducted in computing the taxpayer’s taxable income in those years. However, paragraph (c) of the definition of “E” in the definition of non-capital loss under subsection 111(8) limits the carry forward period of an ABIL to 10 years. If it cannot be deducted by the end of the 10 years, the ABIL reverts to the status of a net capital loss to be carried forward indefinitely to be deducted against future taxable capital gains.

The current inclusion rate is 1/2 of the taxpayer's BIL. As the inclusion rate for taxable capital gains decreased from 3/4 to 1/2 for 2000 and subsequent tax years, transitional rules are provided for computing the ABIL for tax years ending before February 28, 2000, and for tax years ending on or after that date, but prior to October 18, 2000. Go to the table in 29.2.2, Inclusion rate for capital gains and losses.

As stated in Income Tax Folio S4-F8-C1, Business Investment Losses, the ABIL that is included as a non-capital loss is determined in the year that the loss arose. It is not subsequently adjusted to the rates used in the year the loss is applied.

The Computing an Allowable Business Investment Loss (ABIL) worksheet is available in the Integras Template Library, listed as ABIL Calculation. The worksheet is also available in the CRA Electronic Library  > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > A-29_3_6 ABIL Calculation.

Offsetting gain - Corporation recommences business

An ABIL may be claimed for a deemed disposition under subsection 50(1) of the ITA of a share of an insolvent corporation. If the corporation recommences carrying on business within the 24 months following the end of the year in which the ABIL was claimed, subsection 50(1.1) of the ITA may apply to recognize a capital gain, if the shareholder still owns the share.

Subsection 50(1.1) provides for the deemed disposition of the share at the earliest time the corporation recommences business activities for proceeds equal to the ACB of the share immediately before the original deemed disposition under subsection 50(1), and it is deemed to have been reacquired at that same amount. As a result, the taxpayer realizes a capital gain, usually equal to the BIL previously claimed.

If the corporation recommences carrying on business more than two years after the end of the year the ABIL was claimed, the share's ACB stays nil, and any increase in the value of the share is taxable when there is a disposition of the share.

29.3.7 Audit issues – Allowable business investment loss

A taxpayer's claim for an ABIL must be supported by the appropriate documents. The type of documents required to verify a BIL cannot be precisely set out. Use critical thinking and common sense to make sure the technical and factual aspects of each case are dealt with appropriately and establish if the information provided by the taxpayer is adequate to support a BIL.

Expenditures incurred by a taxpayer to dispose of property must also be reviewed to make sure they are allowable. Legal fees paid for the sale of shares are deductible; conversely, legal fees paid to determine the amount payable under a loan guarantee are not considered to be incurred for the purpose of gaining income and are not deductible.

Consider using the Questionnaire for Allowable Business Investment Losses available in the Integras Template Library as H.4.5.3 ABIL Questionnaire. The questionnaire is also available in CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > H.4.5.3 ABIL Questionnaire.

This questionnaire and 29.3.10, Audit Steps – Allowable business investment loss claims, help to determine what to look for and the information and documents you need to ascertain if the BIL is valid.

29.3.8 References

Income Tax Folio

• S4-F8-C1, Business Investment Losses

Income Tax Interpretation Bulletins

• IT126R2, Meaning of 'Winding-up'
• IT159R3, Capital debts established to be bad debts
• IT232R3, Losses - Their Deductibility in the Loss Year or in Other Years
• IT262R2, Losses of Non-Residents and Part-Year Residents
• IT302R3, Losses of a Corporation – The Effect that Acquisitions of Control, Amalgamations, and Winding-ups have on Their Deductibility – After January 15, 1987
• IT442R, Bad debts and reserves for doubtful debts
• IT444R, Corporations - Involuntary dissolutions

Court cases

Purpose of the loan

• Blanco et al v The Queen, 1998 (TCC), 98 DTC 1678
• The Queen v E. Byram, 1999 (FCA), 99 DTC 5117

Nature of the corporation and the investment held

• Gill et al v MNR, 1998 (TCC), 98 DTC 2048
• Markovzki v The Queen, 1998 (TCC), 98 DTC 2040
• Vogel v The Queen, 1996 (TCC), 96 DTC 1321

When a debt is a bad debt

• Léger v MNR, 1981 (TCC) (TRB), 81 DTC 294
• Sansoucy v MNR, 1980 (TCC) (TRB), 80 DTC 1276
• Mueller v MNR, 1982 (TRB), 82 DTC 1174
• Granby Construction & Equipment Ltd v MNR, 1989 (TCC), 89 DTC 456

29.3.9 Questionnaire for Allowable Business Investment Losses

This questionnaire, developed by Restricted Audit and intended for the taxpayer to fill out, can be used as a guide. The questionnaire is available in the Integras Template Library as H.4.5.3 ABIL Questionnaire. It is also available in CRA Electronic Library > Compliance Programs Branch Reference Material > Audit > Income Tax – Forms and Letters > Forms > H.4.5.3 ABIL Questionnaire.

Use professional judgment to determine if the claim should be allowed, based on the documentation and information provided.

29.3.10 Audit steps – Allowable business investment loss claims

1. Verification of existence of commercial activity

Activities conducted in the anticipation of establishing a business, but without any actual commercial activity, do not constitute carrying on a business, given the absence of commercial arrangements (contracts) or activities that produce an income or profit.

An organizational structure that supports operating activities is a prerequisite to actual business start-up. If a taxpayer simply provides the capital to support a business without it being active and incurs a loss, they may be able to claim a capital loss, but not a BIL.

What to look for:

If conducting an audit examination to confirm the existence of a corporation's commercial activity, you must verify:

• the corporation's actual operations, including the history of commercial activity;
• where these activities were carried on;
• the tax years involved;
• the payment of various expenses, such as rent, salaries, and public utilities.

What to examine:

• corporation's financial statements and returns;
• corporate books and records;
• shareholder and director minutes and share register;
• operating and sales tax licenses and permits that apply;
• documents for business travel;
• insurance policies and documentation;
• business correspondence;
• telephone lists;
• documentation verifying purchases for resale or to be used in manufacturing products;
• bank statements and paid cheques; and
• any contracts, leases, other legal documents that show business activities were being carried on.

2. Audit examination of the acquisition of shares

You must verify the details about the acquisition of shares to determine, in particular, the ACB, if acquired at arm's length, and if the BIL reductions are applicable.

What to look for:

Documentation and any other audit evidence that confirms:

• date of purchase and disposition of shares;
• amounts paid and purchase terms, agreements;
• type of corporation (Canadian-controlled private corporation (CCPC), SBC); and
• if dealings between the parties were at arm's length.

What to examine:

• share certificates;
• agreements for the purchase or disposition of shares;
• paid cheques, bank statements;
• corporate minute books and share register;
• corporation's charter or other incorporating document; and
• financial statements.

3. Audit examination of the disposition of shares

You must understand the circumstances that led the taxpayer to claim a BIL; whether the disposition was actual or deemed, whether the parties were dealing at arm's length.

What to look for:

• that an actual sale took place; if it did: the consideration received and the terms and conditions of sale;
• outlays and expenses relating to the sale;
• information that helps to determine if the disposition of shares was at arm's length;
• documentation supporting the FMV of the shares;
• information about the payment of dividends; and
• the type of corporation:
  • CCPC;
  • SBC.

What to examine:

• any sale agreements confirming the disposition by the taxpayer;
• supporting documents for related expenditures;
• documents that show how the share value was determined;
• T2 returns and permanent documents that help verify the:
  • value of property used in carrying on business;
  • short-term debt and the likelihood of recovering; and
  • payment of dividends.
• notice of bankruptcy and any related documentation;
• documentation regarding lawsuits and court orders;
• correspondence between the taxpayer and third parties about debt recovery and other matters related to the cessation of business activities;
• winding-up order;
• shareholder and director minute books and share register; and
• articles of incorporation.

4. Audit examination of debts established to be bad debts

What to determine:

• Is the taxpayer a shareholder of the corporation?
• What circumstances gave rise to this debt?
• Were the funds lent to the corporation at less than a reasonable interest rate?
• Did the taxpayer borrow money and then lend it to the corporation?
• How did the corporation use the funds?
• What steps did the taxpayer take to recover the amount owed?
• Did the taxpayer provide sufficient evidence that the amount owing is a bad debt?

What to examine:

• share certificates;
• shareholder and director minute books and share register;
• loan agreement with the corporation providing details of the amounts, terms, and conditions;
• cancelled cheques, verifying that the taxpayer transferred money to the corporation;
• corporation's books and records, including bank statements to verify the receipt of the funds allegedly lent to the corporation
• corporation’s disbursement records to establish how the corporation used the funds: were the funds used to acquire specific property or equipment or as working capital to pay expenses, such as salaries or rent?
• did the corporation use the borrowed funds for income-producing activities?
• any documentation on the steps taken by the taxpayer to recover the amount owing.

5. Audit examination of a debt from a loan guarantee

If payments are made under a guarantee, the taxpayer is considered to have acquired a debt at the time the guarantee is honoured and the debt is equal to the amount paid pursuant to the agreement. It is unusual for a taxpayer to earn income from guaranteeing a debt and satisfy the requirements of subparagraph 40(2)(g)(ii) of the ITA, unless the taxpayer is a shareholder. Although unusual, it is possible for a non-shareholder to receive consideration in return for the guarantee of a debt and this should be verified when reviewing claims for ABILs.

What to look for:

• Was the taxpayer legally obligated to pay the loan?
• Was the guarantee given to gain income? Did the corporation use the funds for income-producing activities?
• Is the taxpayer a shareholder of the corporation for which the loan was guaranteed?
• Is the taxpayer declaring interest payments instead of the actual payments under the guarantee?
• Was the amount paid to a person with whom the taxpayer was dealing at arm's length?
• Was the corporation an SBC:
  • at the time the guaranteed debt was incurred?
  • at any time during the 12 months immediately before the time the first amount became payable under the guarantee agreement?
• Were the funds lent to the corporation at less than a reasonable interest rate? If yes, the loss qualifies as an ABIL, if these conditions are met:
  • The taxpayer is a shareholder of the corporation.
  • The corporation whose debt was guaranteed used the funds from the guaranteed loan to gain income of a business or property.
  • The corporation took all possible steps to obtain funds from money market institutions.
  • The loan to the corporation does not give an undue tax advantage to the corporation.
  • The corporation has permanently ceased to carry on business.

What to examine:

• obtain a copy of the loan guarantee or a written statement from the lending institution that shows the nature and extent of the guarantee;
• documentation with the date the lender asked for payment under the guarantee;
• documentation from the lender setting out details of the outstanding principal and interest at the date the corporation ceased to carry on business;
• actual proof of payment under the guarantee, such as cancelled cheques, a letter of discharge, or similar document from the lending institution that shows that obligations under the guarantee have been met; and
• minute books, share certificates/registry for shareholders and directors.

6. Audit examination of a debt that is a shareholder loan to the corporation

If a corporation defaults on a shareholder's loan, the shareholder is entitled to claim an ABIL.

What to look for:

• Verify the details of the shareholder's loan account to establish the exact amount owing by the corporation to the taxpayer.
• Verify the amount lent. Review the paid cheques in support of the payment of funds to the corporation and the corporation's bank statements and other records to confirm receipt of the funds.
• Determine if the taxpayer borrowed money from a bank or other person for the purposes of lending it to the corporation. Verify the original amount of the loan and the interest rate for the loan agreement. Examine the taxpayer's return to determine if interest expense was claimed for monies borrowed and lent to the corporation.
• Verify the corporation's use of the funds. Determine if income-producing property was acquired for the business with the shareholder loan proceeds.
• Obtain any available documentation indicating the steps taken by the taxpayer to recover the funds lent to the corporation.

What to examine:

• Examine the corporation's income tax returns to determine if:
  • the notes to the financial statements specify the interest paid on the shareholder loan; and
  • the corporation claimed interest relating to the loan.
• Review the taxpayer's return to determine if the interest income was reported.
• Consult the shareholder loan agreement with the corporation, if any, to confirm that the funds are repayable by the corporation and bear interest.

29.4.0 Farm losses and restricted farm losses

29.4.1 Overview

Taxpayers carrying on some degree of farming activity, whether as an individual, partnership, trust, or a corporation, often incur losses from those farming activities. Whether those losses can be deducted wholly, in part, or not at all from other sources of income in determining the taxpayer's income for a tax year under section 3 of the ITA, depends on which of three categories of farmer that the taxpayer fits into; those taxpayers whose farming losses:

1. are fully deductible in the year against the taxpayer's income from any other source;
2. while deductible in the year, are restricted pursuant to subsection 31(1) to a maximum of $17,500, with any excess loss, called a "restricted farm loss," deductible from any farming income in future years; or
3. are not deductible at all because the taxpayer's farming activities are not undertaken in pursuit of profit (commercial activity) but, instead, constitute a personal endeavour.

29.4.2 Farming defined

 “Farming” is defined by a non-exhaustive list in subsection 248(1) of the ITA; the courts have also found these activities to be farming:

• tree farming;
• cultivating crops in water or hydroponics;
• aquaculture;
• growing Christmas trees;
• operating a feedlot;
• operating a game reserve;
• brooding operation;
• woodlots operating as farms;
• operating a wild game reserve;
• sod farming; and
• operating a sugar bush.

In specific circumstances, these activities are considered farming:

• raising fish;
• market gardening;
• operating nurseries and greenhouses; and
• operating a hatchery.

For a more complete discussion of what constitutes farming, go to Income Tax Interpretation Bulletin IT433R, Farming or Fishing - Use of Cash Method.

29.4.3 Farming as a business

A farming business exists in a given year if the farming activity is undertaken in the pursuit of profit (commercial activity), so that it constitutes a source of income and the actual farming activity carried on fits within the definition of farming.

Note that, based on the case of Levy v MNR, 1985 (TCC), 85 DTC 450, a "farming business" can exist even if all the work is done by others.

It is generally not difficult to recognize the more traditional farm operations that are a legitimate full-time farming operation carried on by a taxpayer as a business, whether the farming is carried on by an individual, a partnership, or a corporation. The modern, full-fledged farming operation has become vast in scope and frequently requires the investment of hundreds of thousands of dollars in capital in land, buildings, inventory, and the huge machinery needed to cultivate the thousands of acres of land often involved.

However, the determination of to what extent losses incurred by the smaller, frequently one-person farming operation are deductible, is a difficult task, particularly in the early, formative years.

29.4.4 Inventory adjustments: Farm income computed using the cash method of accounting

In computing income from a farming or fishing business, a taxpayer may elect to use the cash method of accounting, in accordance with the rules set out in subsection 28(1) of the ITA. The taxpayer makes the election simply by filing an income tax return and reporting farming (or fishing) income for the year using the cash method of accounting. For more information, go to Income Tax Interpretation Bulletin IT433R, Farming or Fishing - Use of Cash Method.

In computing farming income using the cash method of accounting, subsection 28(1) provides for two separate inventory adjustments, one optional and one mandatory. For more information, go to Income Tax Interpretation Bulletin IT526, Farming - Cash method inventory adjustments.

Optional inventory adjustment

Paragraph 28(1)(b) provides for the inclusion of an amount in computing farming business income for a year using the cash method of accounting based on the FMV of the inventory owned at the end of the year in connection with the farming business. The amount of the optional adjustment cannot exceed the inventory's FMV less any mandatory inventory adjustment.

Any amount so included in farming income for the year is deducted in computing the farming business income in the following year in accordance with paragraph 28(1)(f).

Mandatory inventory adjustment

A mandatory inventory adjustment under paragraph 28(1)(c) must be included in computing income for a tax year if there is:

• a loss from the farming business in the year computed in accordance with the cash method of accounting (without the optional inventory adjustment); and
• inventory owned in connection with the farming business at the end of the year that had been purchased by the farmer; for example, purchased supplies and livestock on hand.

The adjustment is made to reduce or eliminate losses if amounts expensed (under the cash method of accounting) are still held in value in inventory; however, the mandatory inventory adjustment cannot create net income from the related farming business as it cannot exceed the net farm loss otherwise determined.

The amount that must be added to the income is the lesser of the:

• net farm loss under the cash method of accounting, before the optional and mandatory inventory adjustments; and
• value of the inventory purchased, during the year and previously, and still owned by the farmer at the end of the year. (The inventory, excluding horses and pedigreed cattle, is valued under subsection 28(1.2) at the lesser of the purchase price or its FMV).

Any amount to be computed in the income for a year is deducted the following year, in accordance with paragraph 28(1)(f).

29.4.5 Farm losses not deductible - No source of income

On May 23, 2002, the Supreme Court of Canada (SCC) rendered its decisions in Stewart v The Queen, 1998 (TCC), 98 DTC 1600, and The Queen v Walls et al, 2002 SCC 47. These decisions affect Audit's approach in determining whether an activity constitutes a commercial activity, therefore giving rise to a source of income.

Audit procedure

As a result of these SCC decisions, the reasonable expectation of profit (REOP) test should no longer be used as the primary test to determine whether a taxpayer's farming activities constitute a source of income for the purposes of section 9 of the ITA. While conducting an audit, it must first be determined if an activity is undertaken as a commercial activity or as a personal endeavour. If there is no personal element present, then a commercial activity exists, and REOP is no longer relevant. The audit is continued using the provisions available under the ITA. REOP is only considered as one of a series of factors if there is a personal element.

The following two-stage approach from Stewart should be used to determine whether a taxpayer's farming activities constitute a source of business or property income:

1. Is the taxpayer’s activity undertaken in pursuit of profit or is it a personal endeavour?
2. 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 a source of income exists, more specifically, if the activity is of a commercial or personal nature. The second stage classifies the source as being either business or property.

If the taxpayer's farming activities do not constitute a source of income, the taxpayer is not entitled to deduct losses relating to those activities.

Commercial activity

If the taxpayer's farming activity is clearly commercial and there is no personal or hobby element, the pursuit of profit is established. Therefore, there is a source of income from a commercial activity regardless if the taxpayer has a history of losses. In such cases, REOP cannot be used to deny a loss. A further analysis related to REOP is not necessary.

However, it may be necessary to review the deductibility of certain expenses for the purposes of paragraph 18(1)(a), "general limitations," paragraph 18(1)(h), "personal and living expenses," and section 67, "general limitation re expenses" of the ITA. Whether an expense was incurred to earn income from business or property and is reasonable in amount, is a question of fact. Whether or not a source of income exists is a separate question from the deductibility of expenses.

Personal endeavour or hobby

If the taxpayer's farming activity may be considered a personal endeavour or hobby, the activity is considered a source of income only if it is undertaken in a sufficiently commercial manner.

For an activity to be classified as commercial in nature, the taxpayer must have some evidence of businesslike behaviour. It is at this stage of the audit those factors established by the Supreme Court case of Moldowan, which formed the basis of the REOP analysis, may be considered.

Those factors are the:

• profit and loss experience in past years;
• taxpayer's training;
• taxpayer's intended course of action; and
• capability of the venture as capitalized to show a profit after charging capital cost allowance (CCA).

As well, consideration can be given to:

• development of the farm to date;
• time spent on the farm operation; and
• extent of farming activity compared to farms of a comparable nature and size in the same area.

This is not an exhaustive list. Other factors, as well as those listed, may arise depending on the nature and extent of the farming activity undertaken by the taxpayer. Each case must be assessed based on its facts. It must be emphasized that REOP is only one consideration and not determinative on a stand-alone basis. It is only used after it has been determined there is a personal element and the auditor is trying to resolve what portion of a farming activity is commercial.

If, after a thorough analysis of the farming activity using the approach above, no part of the farming activity can be considered commercial in nature, no source of income would exist and therefore, the taxpayer would be precluded from deducting losses.

For all audits where a taxpayer's farming activity could be classified as a hobby or there is an element of personal pursuit, it is important to determine if it is being carried on in a sufficiently commercial manner to constitute a source of income. Once this is established, additional audit steps are required to determine the deductibility of expenses. Again, particular attention should be given to paragraph 18(1)(a), "general limitations," paragraph 18(1)(h), "personal and living expenses," and section 67, "general limitation re expenses" of the ITA.

29.4.6 Chief source of income

Aside from the consideration of whether the farming activity constitutes a source of income (commercial activity) such that various expenses may be deducted in calculating income from that activity, for a loss from farming to be fully deductible in a tax year under the ITA, the taxpayer's main, or chief source of income for that year must be from farming or from a combination of farming and a secondary source of income. The farming operations must provide the majority of the income or be the centre of the taxpayer's work routine and their major preoccupation.

When the farming operation is clearly commercial, that is, it has been undertaken in pursuit of profit, the activity would constitute a source of income.

As stated by the Supreme Court of Canada, this category of farming operation includes:

"Taxpayers that earn their livelihood from the principal activity of farming and whose operations are profitable or potentially profitable, as demonstrated by the taxpayer's expertise, commitment of capital, and intended course of action. When the farm is considered a viable business and the farm operation is the taxpayer's major preoccupation, all farming losses can be deducted from other sources of income."

29.4.7 Restricted farm losses

Section 31 of the ITA operates to restrict the amount of farming loss that a taxpayer, whose chief source of income “is neither farming nor a combination of farming and some other source of income,” that is a subordinate source of income for the taxpayer. The amount of farming loss deductible in the year is limited to the lesser of:

• the farm loss for the year, and
• $2,500 plus the lesser of:
  • one-half of the farm loss in excess of $2,500; and
  • $6,250 for tax years that end before March 21, 2013
  • $15,000 for tax years that end after March 20, 2013.

The maximum amount, then, of a farming loss deductible in the year by a taxpayer to which subsection 31(1) applies is $8,750 for tax years that end before March 21, 2013, and $17,500 for tax years that end after March 20, 2013.

Section 31 applies if the farming operation clearly represents a source of income from a commercial activity, but it constitutes a secondary or sideline activity of the taxpayer. In other words, the taxpayer spends most of their time and effort on earning income from other sources, such as an unrelated business or employment.

For a farm operation to be considered the centre of work routine, the taxpayer must show that both time and capital factors favour the farming business. Time and capital are cumulative measurements and not determined year-by-year in isolation.

With respect to time, both the cumulative and the value aspect equate to focus of life and centre of work routine. Examine the number of hours per week and number of years devoted to farming compared to the other income sources. Also, what was the focus of the taxpayer's routine; was their schedule arranged to give farming priority?

The facts of each case determine if section 31 applies. There is not an across-the-board test.

The excess farm losses where subsection 31(1) applies, that cannot be deducted in computing income for the year, constitute a "restricted farm loss" (RFL) for the tax year under subsection 31(1.1). This RFL can be carried forward up to 20 years or back 3 years, and deducted in computing the taxpayer's taxable income in those years, but only to the extent of the taxpayer's farming income in those years.

A "combination of farming and some other source of income"

Subsection 31(1) refers to a taxpayer whose chief source of income is neither farming nor "a combination of farming and some other source of income," but who is allowed to deduct the farm loss in the year from other sources, to the extent permitted by that subsection. The last reference to a "combination" of income sources means that the taxpayer may also have investment income or a secondary source of income from another occupation or business. This secondary occupation or business represents a minor preoccupation for the taxpayer and need not be related to the farming operation.

In the case of The Queen v Twigg, 1996 (FCTD), 96 DTC 6297, the issue was whether the taxpayer, an accountant, could deduct the full amount of his losses of his horse farm. The Federal Court ruled that the farm losses were restricted under subsection 31(1) and concluded:

The consistent and stable profitability of the taxpayer's accounting practice indicated that it was the chief source of income as opposed to farming, which had a history of losses; in a combination case, "where farming is not the taxpayer's major preoccupation, or where the other business is not subsidiary or auxiliary to farming, the taxpayer's chief source of income cannot be viewed as a combination of farming and another revenue source."

The Supreme Court Case of Moldowan v The Queen, 1977 (SCC), 77 DTC 5213, requires a comparative, objective, and relative analysis of the three factors of time, capital, and profit potential. The focus of the determination is normally on "farm profitability" if a taxpayer has ongoing income from employment, a profession, or a pension. For example, some taxpayers enter farming after establishing a non-farming career, or retiring, and have off-farm sources of income that support their lifestyle.

However, to balance these three factors (capital committed to farming, time spent farming, and profitability of the farm), we must consider the taxpayer's specific circumstances. The focus of the determination is normally on “capital committed to farming” and “time spent farming” if a full-time farmer is forced to seek additional off-farm income to offset losses incurred.

Based on the facts of Kroeker v The Queen, 2002 FCA 392, 2002 DTC 7436, and Taylor v The Queen, 2002 FCA 425, 2002 DTC 7596, the "significant profitability" analysis which was used in The Queen v Donnelly, [1998] 1 FC 513, 97 DTC 5499, wasn't necessary, only "potential profitability." Donnelly considered whether farming was a chief source of income, where both Kroeker and Taylor looked at the concept of farming in combination with some other source as being the chief source of income.

These cases have clarified the factors for determining the application of section 31. Moldowan has been the cornerstone on defining the three classes of farmer. Donnelly provides clarification on what may be considered a “chief source of income.” Moldowan said that when farming is only the chief source in combination with another source, the other source must be subordinate to farming when considering the factors; Kroeker helps to give perspective. Stewart provides the criteria to examine the personal element when determining if a source of income actually exists.

Although Moldowan has been used for defining the classes of farmers, its interpretation of “chief source of income is a combination of farming and some other source” is likely the most contentious aspect of the case. In August 2012, the Supreme Court overturned Moldowan in its ruling on The Queen v Craig, 2012 SCC 43, where it said that the ITA did not require that the “other” source of income be subordinate to farming. The budget for 2013 (bill C-60) clarified that for tax years ending after March 20, 2013, the other source(s) must be a subordinate. This has essentially put the restriction of farm losses back to the rules defined in Moldowan.

Bill C-60 also amended subsection 31(2) for tax years ending after March 20, 2013. This subsection indicates that a farm loss will not be restricted if the taxpayer’s chief source of income for the year is a combination of farming and manufacturing or processing in Canada of goods for sale and all or substantially all (generally means 90% or more) output from all farming business is used in the manufacturing or processing.

Change in occupation to farming

Section 31 does not restrict the initial losses in the first years if a taxpayer is in the process of changing occupations and leaving employment or another business to adopt farming as a chief source of income. A change in occupation to farming means the taxpayer:

• is setting up a farming operation that can represent a means of livelihood by markedly increasing the capital set aside for carrying on the farming business;
• takes the steps necessary to leave the former employment or business, decreasing the time spent on same, while increasing the time spent on the farming business; and
• has set a timetable for making farming his chief source of income.

29.4.8 Audit procedures to determine chief source of income

To determine whether a farming business is the taxpayer's chief source of income, for each tax year, take the following elements into account:

• gross income;
• net income;
• taxpayer's participation, personal work, time spent on the business;
• number of employees;
• capital invested, self-financing;
• current and future profit outlook for the farming business; and
• taxpayer's plans for maintaining and developing the farming business.

If the taxpayer is a member in a farming business carried on as a partnership, the test is a separate consideration for each member and stands on its own merits for that member.

The auditor must consider applying section 31 of the ITA if a taxpayer claims a farm loss deduction and the business constitutes a source of income; establish a summary of the taxpayer's income for the current year and the four years immediately prior, based on the model in 29.4.11, Schedule A: Summary of taxpayer's income and composition of farm loss.

Reduction of restricted farm loss

If section 31 of the ITA is applied on reassessment, give the taxpayer the opportunity to reduce the restricted farm loss to be carried forward to subsequent years. The taxpayer may also request in writing to:

• reduce any CCA or other permissive deductions claimed;
• include an optional inventory adjustment under paragraph 28(1)(b); or
• increase any optional inventory adjustment already included in computing the farm loss under the cash method of accounting.

29.4.9 Example - Compute an allowable farm loss and a restricted farm loss

For the tax year ended December 31, 2019, Bernard has income of $50,000 from operating a retail sales business as a sole proprietorship. He has also incurred a $20,000 loss from operating a farming business to which section 31 of the ITA is considered to apply. The loss includes a $2,000 deduction for SR&ED under section 37.

Under section 31, Bernard's farming income (loss) is determined as follows: 

In the year, Bernard can deduct $12,250 of the $20,000 loss he incurred operating a farming business. The remaining $7,750 represents his restricted farm loss for the loss year, which he can then carry back 3 years or forward 20 to deduct from farming income reported in those years.

29.4.10 Farm losses - References

Income Tax Interpretation Bulletins

• IT206R, Separate businesses
• IT232R3, Losses - Their Deductibility in the Loss Year or in Other Years
• IT322R, Farm Losses
• IT364, Commencement of Business Operations
• IT373R2-CONSOLID, Woodlots
• IT433R, Farming or Fishing - Use of Cash Method
• IT526, Farming - Cash method inventory adjustments

Court cases

• The Queen v Craig, 2012 SCC 43
• Stewart v The Queen, 2002 SCC 46
• The Queen v Walls et al, 2002 SCC 47
• Miller v The Queen, 2002 (TCC), 2003 DTC 6
• Enright v The Queen, 2002 (TCC), 2002 DTC 1969
• Vachon et al v The Queen, 2002 (TCC), 2003 TCC 1484
• Durber v The Queen, 2002 (TCC), 2002 DTC 3899
• The Queen v Twigg, 1996 (FCTD), 96 DTC 6297
• Moldowan v The Queen, 1977 (SCC), 77 DTC 5213

Other reference

• Tax Guide T4002, Self-employed Business, Professional, Commission, Farming, and Fishing Income

29.4.11 Schedule A: Summary of taxpayer's income and composition of farm loss

Reference: Go to Income Tax Interpretation Bulletin IT232R3, Losses – Their Deductibility in the Loss Year or in Other Years. 

29.5.0 Loss carryovers

29.5.1 Application of losses

Subsection 111(1) of the ITA sets out five types of losses of other years that can be deducted by a taxpayer in computing the taxable income for a tax year and their respective loss carryover periods:

1. non-capital losses: back 3 years and forward 20;
2. net capital losses: back three years and forward indefinitely;
3. restricted farm loss (RFL): back 3 years and forward 20 years (only to extent of farming income in the year);
4. farm loss: back 3 years and forward 20; and
5. limited partnership loss: carried forward (only) indefinitely.

Include current year losses to calculate net income in accordance with section 3. In general, if the net income for the year is a negative amount, the amount is considered to be a non-capital loss. No amount is deductible for a non-capital loss, net capital loss, RFL, or farm loss, if it has been deducted in previous years. In applying each type of loss, the taxpayer must deduct the earliest loss incurred of that type.

Become familiar with the contents of Income Tax Interpretation Bulletin IT232R3, Losses – Their Deductibility in the Loss Year or in Other Years, the primary technical reference on the application of losses.

29.5.2 Carryover of non-capital losses

"Non-capital loss" is defined in subsection 111(8) of the ITA.

Non-capital losses, including those from farming and fishing, may be carried forward up to 20 years.

The result of the non-capital loss calculation is that a taxpayer's losses for the year from activities, other than farming or fishing, are first applied as a deduction against the taxpayer's income for the year from activities other than farming or fishing. To the extent that any loss still remains, it is applied as a deduction against any income of the taxpayer for the year from farming or fishing activities. If a loss from such non-farming or fishing activities still remains, it generally qualifies as a non-capital loss.

29.5.3 Carryover of listed personal property losses

"Listed personal property loss" is defined in subsection 41(3) of the ITA.

29.5.4 Carryover of farm losses

"Farm loss" is defined in subsection 111(8) of the ITA.

A farm loss must be computed at the same time as a non-capital loss.

Restricted farm losses
"Restricted farm loss" (RFL) is defined in subsection 31(1.1).

29.5.5 Carryover of limited partnership losses

"Limited partnership loss" is defined in subsection 96(2.1) of the ITA.

29.5.6 Carryover of allowable business investment losses

"Allowable business investment loss" is defined in paragraph 39(1)(c) of the ITA.

29.5.7 Carryover of net capital losses

The term Net capital loss (NCL) is defined in subsection 111(8) of the ITA. Computing the NCL deduction is important since the inclusion rate in section 38 varies according to the year. Subsection 111(1.1) describes how to compute the allowable NCL deduction; the NCL amount is adjusted to the rate for the year the loss is applied. Further to the capital gains exemption coming into force, NCLs after May 22, 1985, are deductible only from taxable capital gains.

29.5.8 Other considerations

Order in which losses are applied

A taxpayer may deduct from their taxable income any portion of a loss that has not already been deducted and may choose the order that the following losses are deducted:

• non-capital losses - paragraph 111(1)(a) of the ITA;
• net capital losses - paragraph 111(1)(b);
• restricted farm losses - paragraph 111(1)(c);
• farm losses - paragraph 111(1)(d); and
• limited partnership losses - paragraph 111(1)(e).

However, subsection 111(3) requires that losses of the same kind incurred over several tax years be deducted in chronological order.

In computing taxable income for 1983 and subsequent tax years, any request to replace one kind of loss by another that has already been applied will be granted, as long as the year in question can be reassessed in accordance with subsection 152(4).

Order of certain deductions when computing an individual's taxable income

To compute an individual's taxable income, section 111.1 stipulates the order that certain deductions must be applied:

1. Certain deductions permitted under section 110, including those relating to stock options given to employees, workers' compensation benefits, and social assistance payments.
2. Deductions permitted under section 110.2 relating to lump sum payments.
3. Losses allowable under section 111.
4. Capital gains deductions for eligible farm property and eligible small business shares under section 110.6.
5. Northern residents allowances under section 110.7.

Losses of other years - Loss carryover bankruptcy

¹ No loss can be carried forward to post-bankruptcy or on any subsequent tax year prior to the year where discharge is granted (for example bankruptcy in 2011, discharge in 2013, year not eligible 2012). As well, as soon as discharge is granted, none of the losses incurred in years prior to discharge can be carried forward to the year of discharge or years that follow.

² If discharge is granted in the year in which bankruptcy occurred (bankruptcy in 2011 and discharge in 2011), losses incurred in the post-bankruptcy period can be carried forward to any years subsequent to bankruptcy (no other limitation than section 111).

³ Paragraph 128(2)(f) indicates that no deduction for loss carryover can be allowed on the post-bankruptcy return, except if discharge is granted in the year in which bankruptcy occurred (bankruptcy in 2011 and discharge in 2011). In this case, a subsequent year loss could be carried back to the post-bankruptcy return.

⁴ Except for losses that would be incurred in a year prior to the year the discharge is granted: these would be deductible on the in-bankruptcy return (bankruptcy in 2011, loss incurred in 2012, and discharge in 2013).

⁵ All losses incurred in years prior to the year the discharge is granted can be carried back.

Effects of a dissolved corporation's restoration on losses

A corporation can be restored after involuntary dissolution in the Corporate Registry in accordance with applicable legislation for the purposes of assessing their tax return. The ITA does not provide for the restoration of a dissolved corporation. The laws of the incorporating jurisdiction determine the effects of a corporation's involuntary dissolution and its restoration.

If the law in question states that the corporation is restored to its original legal status, losses may be carried forward to a subsequent year if there has been no change in control. Any income earned while the corporation was dissolved reduces the balance of loss carryovers. As well, if the corporation was restored retroactively under the laws of the incorporating jurisdiction, the tax year does not end with the dissolution and a new tax year does not apply when the corporation is restored.

29.5.9 Audit issues - loss carryovers

• First make sure that current year losses are correctly determined and included in computing net income under section 3 of the ITA to the maximum extent possible before being considered as loss carryovers.
• Conduct a follow-up for loss carryovers using the CORTAX T2 or CORPAC-RAPID system and compare the loss carryovers with the income tax returns on hand. Make sure that loss carryovers for a non-capital loss, net capital loss, restricted farm loss, or farm loss were not deducted in previous years.
• Make sure that the taxpayer deducts the earliest loss for each type of loss.
• Examine returns for loss years to make sure that a non-capital loss does not include a business investment loss.
• For losses incurred before a change in control, make sure that the taxpayer did not deduct certain types of losses unless the conditions in subsections 111(4) and (5) are met.
• For losses incurred before a bankruptcy, make sure these losses are first deducted from income on the return prior to bankruptcy. The balance, if applicable, may be used to reduce the income on the bankruptcy return. Go to subsection 128(2).

Examples

Example 1 - Compute the allowable net capital loss under subsection 111(1.1)

An individual incurs a $1,000 capital loss in 1999, resulting in a $750 NCL. In 2019, the individual realizes a capital gain of $1,000, resulting in a taxable capital gain of $500.

The deduction allowed in 2019 for the loss incurred in 1999 is $500, or the lesser of the:

• taxable capital gain: $500
• total adjusted NCL:   $750 x (1/2 / 3/4) = $500

Following an audit, the taxpayer's income is increased from $15,000 to $40,000 for the 2018 tax year.

Since the taxpayer is allowed to change how the loss is applied, the proposal letter asks the taxpayer to specify how they prefer to reallocate the losses. A change to the losses deducted in 2018 requires a corresponding change to the amount deducted in 2019. Consequently, if the taxpayer asks to change the 2018 deduction, the 2019 return has to be reassessed.

Example 3 - Changes to farm loss carryovers

A taxpayer reports:

• farm loss of $18,000, which is subject to section 31 (farm loss of $10,250 deductible in the year plus restricted farm loss of $7,750);
• income of $40,000 from a clothing business;
• ABIL of $42,000; and
• Subdivision e deductions of $3,000.

29.5.10 Loss carryback administrative procedures

To carry back current year non-capital farming and fishing losses to any of the three preceding tax years, taxpayers should fill in and include the appropriate form with the current year income tax return:

• Form T1A, Request for Loss Carryback
• Form T2SCH4, Schedule 4, Corporation Loss Continuity and Application
• Form T3A, Request for Loss Carryback by a Trust

Amended returns should not be filed. A taxpayer must make a written request to carry any loss forward to a subsequent year.

For more information, go to 11.3.3, Application of losses.

29.5.11 References

Income Tax Folio

• S4-F7-C1, Amalgamations of Canadian Corporations

Income Tax Interpretation Bulletins

• IT232R3, Losses - Their Deductibility in the Loss Year or in Other Years
• IT262R2, Losses of Non-Residents and Part-Year Residents
• IT302R3, Losses of a Corporation - The Effect that Acquisitions of Control, Amalgamations, and Winding-ups have on Their Deductibility - After January 15, 1987
• IT444R, Corporations - Involuntary dissolutions
• IT523, Order of provisions applicable in computing an individual's taxable income and tax payable

Income Tax Information Circular

• IC84-1, Revision of Capital Cost Allowance Claims and Other Permissive Deductions

Income Tax Ruling

• 9628845(E), November 22, 1996, Revival of a Dissolved Corporation - Impact on Losses

Learning products

• TD1001-000, Losses: Tax Concepts, Current Year Losses and Losses Carried Over 
• TD1002-001, Losses - Acquisition of Control: Preliminary Concepts
• TD1002-002, Losses: Acquisition of Control