Good news came down for business investors from the Supreme Court of Canada, Thursday. In two companions cases, Stewart v. Canada and Wall v. Canada, the SCC has ruled that the “reasonable expectation of profit” test, which is often relied on by the Canada Customs and Revenue Agency and the courts to deny business deductions, has become a broad-based tool improperly used to second-guess bona fide commercial decisions.
Use of this test amounts to judicial activism at worst, and unfair and arbitrary treatment of taxpayers at best, said the majority of the SCC. Instead of the REOP test, the country’s top court set out a new test to be used by the CCRA and the courts when dealing with business expense deductions.
In the first of the two cases, Stewart v. Canada, Toronto resident, Brian Stewart, an experienced real estate investor, acquired four condos for the purpose of earning rental income. The properties were part of a syndicated real estate development. All units were highly leveraged with Stewart paying only $1,000 for each unit.
Prior to the purchase, Stewart was given projections of rental income and expenses for each of the properties that included a negative cash flow that would produce income tax deductions for a 10-year period. However, the actual rental experience ended up being worse than what had been projected. For the taxation years 1990 to 1992, Stewart claimed signifcant losses, mainly as a result of significant interest expenses on money borrowed to acquire the units.
These losses were disallowed by the CCRA on the basis that Stewart had no reasonable expectation of profit. Both the Tax Court of Canada and the Federal Court of Appeal upheld the CCRA’s decision.
But good news for the taxpayer came today when the Supreme Court of Canada reversed the lower court decisions, and upheld Stewart’s appeal.
The following two-stage approach should be employed to determine whether a taxpayer’s activities constitute a source of business or property income:
- Is the taxpayer’s activity 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 is only relevant when there is some personal or hobby element to the activity, said the SCC. Where the nature of an activity is clearly commercial, the taxpayer’s pursuit of profit will be a given.
There is no need to delve any deeper into the taxpayer’s business operations, said the court. But when the nature of a taxpayer’s activity suggest that it could be considered a hobby or other personal pursuit, it will be considered a source of income only if it is undertaken in a sufficiently commercial manner. For an activity to be classified as commercial, the taxpayer must intend to make a profit and the CCRA must have evidence to support their allegation to this effect. The mere reasonable expectation of profit is only one single factor, among others, to be considered.
Once it has been determined that an activity is sufficiently commercial to be considered a source of income, the CCRA’s inquiry into deductibility should be undertaken using the Act’s provisions as a guide — not the REOP test. To deny the deduction of losses on the simple ground that the losses signify that no profit exists runs afoul of the language and the purpose of the Income Tax Act, said the court.
In this case, Stewart purchased four rental properties which he rented to arm’s length parties in order to obtain rental income. A property rental activity which, as here, lacks any element of personal use or benefit to the taxpayer is clearly a commercial activity. As a result, Stewart satisfied the test for source of income and is entitled to deduct his rental losses.
In the second of the companion cases, Walls v. Canada, B.C. residents, Jack Walls and Robert Buvyer, were limited partners in a partnership. A mini-warehouse was purchased from Fraser Storage Park Ltd. on behalf of the partnership for $2.2 million payable in the form of $1 in cash and the balance in the form of an agreement for sale with interest payable at 24% a year. The partnership also agreed to pay interest, service fees, and management fees, as well as 50% of the net operating profit of the operation to FSPL, on an annual basis.