Income from Business: General Concepts and Rules Chapter 4 Income from Business: General Concepts and Rules

Business Income Income from a business (sec. 9) What is profit? The role of GAAP

Business Income vs. Capital Receipt Why is distinction important? Income receipts are fully taxed Capital receipts are only partially taxed as capital gains To determine, courts look at taxpayer intention Observable behavioural factors or “badges of trade”

Steps to Addressing Income vs. Capital Gain Issue Gather all the facts leading up to, during, and after the transaction. Develop your best arguments for both income treatment and capital gain treatment. Be balanced in your analysis. Consider the “badges of trade” in Exhibit 4-1. Analyze the strengths and weaknesses of your arguments. Arrive at a conclusion of income or capital gain consistent with your analysis. Determine how the transaction will be taxed if the taxpayer is: an individual, or a corporation.

Exhibit 4-1

Income vs. Capital Damages Non-performance of business contract Cancellation of agency agreements Loss of property

Other Receipts or Benefits Profits from an illegal business Profits from betting, gambling, and windfalls Subsidies Forgiveness of debt rules

Business Income vs. Property Income Property held to earn income is either: Income/loss from a business; or Income/loss from property. On disposition of property, proceeds less the cost will either be: Capital gain/loss; or Income or loss from business or from property.

Business Income or Property Income Whether the source is property or business income depends on whether taxpayer has purchased “property” or inventory Basic test of whether income is from business or property: Is income earned active or passive?

Business Income or Property Income Important because: Most property income excluded from calculation of: maximum RRSP contribution limit “earned income” used for eligibility of child care expenses Property income derived from rental properties subject to separate rules Business income earned by a corporation has special rules (SBD, M&P deduction) Income attribution rules Non-resident taxation

Inventory Valuation Basis of Valuation: Market or lower of cost or market Specific identification First in, first out (FIFO) Note: adjustment required for amortization allocation to inventory in Absorption Accounting

Sole Proprietorship Generally, must report on a calendar basis Election available for alternative fiscal year but additional rules for reporting business income apply

Accounting Income to Net Business Income for Tax Purposes Income from a business for tax purposes is equal to: Start with: ssec. 9(1) Accounting net income (“Profit”) ADD: secs. 12 to 17 Income inclusions not included in “profit” ssec. 18(1), 19 Disallowed expenses and reserves sec. 67 Unreasonable amounts Capital losses – book losses on the disposal of capital property MINUS: ssec. 20(1) Expenses specifically allowed but not allowed in “profit” Capital gains – book gains on the disposal of capital property EQUALS: Income from a business for tax purposes

Inclusions in Income for Tax Purposes ITA Reference Description Related References 12(1)(a) Services to be rendered in future 20(1)(m), (m.2) 12(1)(b) A/R for services rendered 20(1)(n), 68 12(1)(d), (e) Reserves – Bad debts and warranties 20(1)(l), (m), (n) 12(1)(f) Insurance proceeds – depreciable property 12(1)(g) Payments based on production or use 12(1)(i) Bad debts recovered 12(1)(c), (j), (k) Interest, Dividends 82(1), 84, 89 12(1)(l) Partnership income 96 to 103 12(1)(x) Inducement payments, reimbursements 20(1)(hh)

Inclusions Amounts received or receivable Inducement payments or reimbursements Restrictive covenants Partnership income Barter transactions

Deductions Section 18 – disallowed or restricted deductions Act does not specify all deductible expenses Thus, expense is usually deductible for tax purposes if: Deductible using GAAP; Not a capital expenditure; Incurred to earn income for tax purposes; Not a personal expense or expenditure; and Reasonable in the circumstances.

Summary of Deductions Specifically Not Deductible or Restricted Sec. 18 ITA Reference Description 18(1)(a) Not deductible unless incurred to earn income from business or property 18(1)(b) Capital expenditures including depreciation, obsolescence or depletion except as expressly permitted 18(1)(c) Expense incurred to earn exempt income 18(1)(e) Reserves and contingent liabilities 18(1)(h) Personal or living expenses 18(1)(l) Use of recreational facilities and club dues

Summary of Deductions Specifically Not Deductible or Restricted Sec. 18 ITA Reference Description 18(1)(n) Political contributions 18(1)(p) Personal service business expenses 18(1)(r) Automobile mileage rates 18(1)(t) Interest and penalties under the Income Tax Act or interest under the Excise Tax Act 18(2) Interest and property taxes on land 18(3.1) Costs related to construction of building or ownership of land 18(9) Prepaid expenses 18(12) Workspace in the home limitations 18(13) Superficial loss

Summary of Deductions Specifically Not Deductible or Restricted Sec. 67 ITA Reference Description 67 Outlay or expense must be reasonable in the circumstances 67.1 Expenses for food and entertainment 67.2 Interest on loans to buy a passenger vehicle 67.3 Costs of leasing a passenger vehicle 67.5 Illegal payments 67.6 Fines and penalties

Deductibility of Expenses General test: To gain or produce income An expense or outlay must: Be made or incurred by the taxpayer for the purpose of gaining, producing, or maintaining income; and Be expected to generate income related to the taxpayer’s business or property. Expenditure of a capital nature Personal and living expenses

Other Restrictions Accrued Expenses Unpaid amounts between non-arm’s length parties Must be paid within two years of the end of the taxation year in which it was declared payable or accrued If unpaid after this time, included into income Election available to have unpaid amount deemed paid Unpaid remuneration and other amounts Must be paid within 179 days of end of the taxation year in which the expense was incurred

Reasonable Expectation of Profit (REOP) Checklist for evidence REOP: Manner in which activity is operated Elements of personal pleasure or recreation Expertise of the taxpayer or his/her advisers History of income and loss Time and effect expended Financial status of taxpayer Amount of occasional profits Sale or discontinuance of activity Success of taxpayer in other activities Expected appreciation of asset value

Limitations on Deductible Expenditures Must be “reasonable in circumstances” Limitations specifically on: Food, beverages, and entertainment Interest on funds borrowed to purchase a passenger vehicle Costs of leasing a passenger vehicle Illegal payments Fines and penalties

Deductions Specifically Permitted Sec. 20 ITA Reference Description Related References 20(1)(a) Capital cost allowance 18(1)(b) 20(1)(b) Cumulative eligible capital amount 20(1)(c), (d) Interest IT-533 20(1)(e) Expenses of issues shares or borrowing money 20(1)(e.2) Premiums on life insurance used as collateral 18(1)(c) 20(1)(f) Discount on debt obligations 20(1)(l) to (p) Reserves 18(1)(e) 20(1)(q) Employers contribution to RPP 147.2

Deductions Specifically Permitted Sec. 20 ITA Reference Description Related References 20(1)(y) Employer’s contribution under a DPSP 147(8) 20(1)(z) Cancellation of lease 18(1)(q) 20(1)(aa) Landscaping of grounds 18(1)(b) 20(1)(cc) Expenses of representation 20(1)(dd) Investigation of site 20(1)(ee) Utilities service connection 20(1)(qq), (rr) Disability-related modifications and equipment 20(10) Convention expenses

Reserves Only deductible if specifically permitted under Part I of Act Deductible reserves include: Reserve for doubtful debts; Reserve for goods not delivered and services not rendered; Manufacturer’s warranty reserve for amounts paid or payable to an insurer to insure liability under warranty agreement; and Reserve for an amount not due until a later year under an instalment sales contract limited by another rule

Reserves Any reserve taken in one year must be brought back into income under ssec. 12(1) in the following year. In that following year, a new reserve can be claimed.

Employer’s Contribution to RPP Two types of RPP: Defined benefit plan and Money Purchase Plan For money purchase plan, total of employer and employee contributions are limited to the lesser of: 18% of employee’s employment income under sections 5 and 6 A specified dollar limit as follows: 2010 2011 2012 2013 2014 $22,450 $22,970 $23,820 $24,270 Indexed

Employer’s Contribution under a DPSP Contributions deductible if paid within year or within 120 days after end of a year Deduction limited to lesser of: ½ of the money purchase dollar limit for the year; and 18% of the employee’s compensation for the year.

Sales/Negotiating Person’s Expenses Ordinary Employee Salesperson/Negotiator Proprietor [s. 8(1)(h), (h.1), (i), (j)] s. 8(1)(f) [s. 8(1)(i), (j)] Home Office: Utilities  Mortgage Interest House Insurance Property Taxes Maintenance and repairs Office Supplies CCA on computer

Sales/Negotiating Person’s Expenses Ordinary Employee Salesperson/Negotiator Proprietor [s. 8(1)(h), (h.1), (i), (j)] s. 8(1)(f) [s. 8(1)(i), (j)] Automobile Expenses: Operating  CCA Interest on loan Convention (excl. meals) Promotional expenses Limit on expenses None Commission income

Ceasing to Carry on Business Sale of accounts receivable Issue: To deduct reserve for bad debts, an amount related to the debt must be included in income Solution: Elect under sec. 22 if Person has sold all or substantially all of the property used in the business Purchaser will continue the business. Sale of inventory

Professional Business A/R in respect of services billed are required to be included in income Work-in-progress (WIP) is considered inventory Election available to exclude from business income any WIP at end of year Allowed for: Accountants, Lawyers, Doctors, and Dentists Excludes: Others such as engineers

Scientific Research and Experimental Development (SR&ED) Definition: “systematic investigation or search carried out in a field of science or technology by means of experiment or analysis . . .”

SR&ED General deduction of expenditures R&D expenditures, including most capital expenditures made before 2014, made in a year are fully deductible Expenditures not deducted in a year are placed in a pool and may be deducted in a future year

SR&ED Pool Current SR&ED Capital SR&ED Expenditures Less: ITC claimed In previous pool Capital SR&ED Expenditures made before 2014 Less: ITC claimed In previous year SR&ED Pool Deducted against Income when needed

SR&ED ITC Investment tax credit (ITC) is a direct reduction of taxpayer’s liability ITC available as a specified percentage of SR&ED expenditures made ITC claimed in current year, reduces SR&ED pool in following year

GST/HST Impact on Business Activity Commercial Activity Carrying on business Adventure or concern in the nature of trade Making of a supply of real property Exclusions: Part of commercial activity that involves making an exempt supply A business engaged by individual, personal trust, or partnership without a reasonable expectation of profit

GST/HST Impact on Business Activity Commercial Activity Value for tax When GST/HST is payable Automobile operating cost benefits paid by employer

GST/HST Impact on Business Activity Input tax credits Available to registrants for GST/HST paid on goods and services that are purchased for use in commercial activity Restrictions: Club memberships Home office expenses Personal or living expenses Reasonableness Automobile allowances

GST/HST Impact on Business Activity Adjustments to Net Tax Excess charges Price reductions Bad debts Lease of passenger vehicles Food, beverages, and entertainment expenses