Articles November 2004

By way of background, the new decisions are concerned with a tax concept known as Reasonable Expectation of Profit or “REOP.” Historically, the CCRA could deny every expense of a business on the basis that there was NO REOP.

To illustrate, suppose Mr. Wright ran an unprofitable business selling spaceship rides to Mars. It would not have been unusual for the CCRA to diplomatically advise Mr. Wright that his business had no reasonable chance of ever making a profit; therefore his business expenses, and overall business losses, were not deductible against other income.

It is the very fact that the losses from an unprofitable enterprise are being deducted against other income that pushes auditors to make a REOP assessment. I have never heard of REOP being argued by the CCRA for an incorporated taxpayer. CCRA auditors are irked by taxpayers writing off losses incurred pursuing crazy schemes or hobbies.

More irksome for the many taxpayers subjected to REOP assessments, is that in applying REOP the CCRA substituted its judgement (in hindsight) for that of the taxpayer running the business. To stretch the analogy, a hundred years ago, Mr. Wright might have been selling rides on an airplane. At the time would anyone have thought that he had a reasonable expectation of profit?

The new test may make the Orville and Wilbur Wrights of the world happy. The Supreme Court states that where an activity is clearly commercial, the taxpayer’s profit motive is established and there is no need to enquire into the business acumen of the person running the business. The court notes that the CCRA would certainly expect its share of the profits if an unprofitable business turns profitable.

Whereas at one time REOP was often cited as a primary reason for disallowing business expenses, now it will only be considered in limited circumstances.

The Supreme Court states that if the business contains elements that indicate it is a hobby or other personal pursuit, expenses will only be deducted if the enterprise is carried on in a sufficiently commercial manner. REOP is one of the factors to consider if the business is being carried on in a commercial manner.

The Supreme Court’s comments on hobbies and businesses with a personal element are an indication that all is far from lost for the CCRA. If I recall my American history correctly, the Wright brothers built bicycles for a living. They built flying machines in their spare time – perhaps as a hobby. Using the Supreme Court’s reasoning, the expenses of that hobby might not be deductible. Maybe the Wright brothers of the world will not be happy with the decisions after all.

The decisions are helpful to those taxpayers operating uncontroversial money losing businesses. For example, if you are running an unprofitable legal practice out of your basement, it is doubtful that the CCRA would argue that the enterprise is an enjoyable hobby. The losses incurred in running such a business should be deductible annually.

More importantly, and regardless of the nature of the business, the expenses that cause a loss are still subject to scrutiny. The Supreme Court does not say that personal expenses can be deducted as business expenses. Nor does the Supreme Court say that the CCRA should not test whether an expense has really been incurred. Therefore, even for uncontroversial money losing businesses, there is still a requirement to provide evidence that shows that losses are legitimate.

Based on recent rulings from the Supreme Court of Canada taxpayers still need to hang on to receipts in case an auditor comes calling. The Supreme Court has sent a message that the CCRA should not be second guessing bona fide business decisions. Since the CCRA has been directed to use REOP in limited circumstances, taxpayers can expect increased scrutiny on the reasonableness of the expenses that have been claimed, particularly in circumstances where a business has been losing money for several years. The effect of the recent Supreme Court decisions is that the CCRA cannot simply recite the REOP mantra as an excuse for denying business losses.

-- J. Andre Rachert

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