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

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

3. 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”

4. 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.

5. Exhibit 4-1

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

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

9. 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.

10. 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?

11. 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

12. 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

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

14. 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

15. 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)

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

17. 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.

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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.

29. 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

30. 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.

31. 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

32. 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

33. 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

34. 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

35. 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 . . .”

36. 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

37. 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

38. 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

39. 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

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

41. 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

42. 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