Midterm 2 - Income from Business or Property

Question 1

Identify and explain the starting points in s. 9 of the Income Tax Act for the determination of income from business or property.

Answer 1

1) income for TP is PROFIT for the taxation year -> determining “profit” therefore central to taxation of income from bus. or prop.
2) “profit” not defined in Act -> determined by COMMON LAW (heavily dependent on ACCOUNTING principles)

The rest of subdivision b of Division B of Part I (ss. 9-37) further modify and reinforce concept of “profit”

Question 2

Explain the context in which the question of whether income is from a business or property source has normally arisen.

Answer 2

Characterization important b/c if not from source, not taxable (s.3(a)) -> characterization also affects tax treatment

Common disputes:
1) employment vs business income - important for deductions available

2) income vs. capital gain - capital gain only taxed half
3) income from business vs income from property - NOT AS IMPORTANT b/c generally NO distinction in ITA (but CAN have different treatment/deductions)

Question 3

Discuss the Income Tax Act statutory meaning of “business” and “property”.

Answer 3

BUSINESS

• INCLUDES profession, calling, trade, manufacture or undertaking and adventure or concern in nature of trade
• but does NOT INCLUDE office or employment
• i.e. NON-EXHAUSTIVE -> look at ORDINARY MEANING; generally profit-motivated activities
• “adventure in nature of trade” = usually isolated, speculative transaction

PROPERTY

• property of ANY KIND (whether real, personal, corporeal or incorporeal)
• includes a) right of any kind, share, chose in action and b) money, unless contrary intention is evident

Question 4

Discuss the common law meaning of “business” and “property”

Answer 4

Business - Smith v Anderson (adopted by SCC in STEWART)
- “anything which occupies time and attention and labour of a person IN THE PURSUIT OF PROFIT”

Property - Manrell (2003 SCC)
- property = legally enforceable right to EXCLUDE OTHERS (i.e. needs to EXCLUDE others –> non-compete doesn’t count b/c can’t exclude others)

Question 5

Give an example of a tax shelter scheme and explain two tax advantages such a scheme can provide.

Answer 5

STEWART case + in-class example

• TP buys properties (mostly on loan, with high interest rate) to create annual LOSS to offset against present income
• TP sells years later -> only pays tax on CAPITAL GAIN

advantages: 1) defer tax by sheltering profits until disposal of property, 2) reduce tax by producing loss against other sources of income then replacing with capital gain (only half taxable)

Question 6

Describe the test used prior to the Stewart case to determine whether an activity carried on by a taxpayer was a business or a hobby

Answer 6

Reasonable expectation of profit (“REOP” ) test –> note: overruled by SCC in STEWART

• under REOP, would only be considered “business” activity if TP had REOP
• based on several factors (SCC kept as non-exhaustive list in Stewart)
  1) profit and loss experience
  2) TP’s training
  3) TP’s intend’d course of action
  4) capacity of venture to prof’t
  5) time spent on activity

Question 7

Describe the approach in the Stewart case to determining whether an activity carried on by a taxpayer is a business or property source

Answer 7

Is endeavour clearly commercial?

If YES –> Business or Property

If NO –> predominant intention of profit? Test: SUBJECTIVE intent against OBJECTIVE factors incl. REOP factors (from Moldowan)

1) profit and loss experience
2) TP’s training
3) TP’s intend’d course of action
4) capacity of venture to prof’t
5) time spent on activity

Predominant intention to profit INCLUDES potential capital gains –> Stewart tax shelter scheme = OK according to SCC

Question 8

Discuss the response to the Stewart case the Minister of Finance proposed in October of 2003.

Answer 8

PROPOSED addition to Act in 2003

1) limit on loss - only count loss if reasonable to expect TP will realize cumulative profit from business or property
2) for limit on loss, profit determined WITHOUT REFERENCE TO CAPITAL GAINS OR CAPITAL LOSSES

• would have restored REOP test prior to Stewart
• > policy concern: could lead to legitimate businesses with losses not being able to claim losses despite decrease in ability to pay
• NOT enacted

Question 9

Discuss the revenue, equity and neutrality concerns with respect to taxpayers claiming a deduction for losses from hobby activities on the basis that they are losses from business or property.

Answer 9

Revenue - deductions = costly to revenue

Equity

• some TPs could claim expenses (e.g. oil painter) but others wouldn’t be able to (e.g. flier) –> horizontal inequity
• other TPs effectively supporting the TP’s hobby –> vertical inequity

Neutrality

• incentive for hobbyists to incorporate
• different tax treatment for different hobbies/activities

Question 10

Identify and briefly explain eight differential treatments of “income from property” and “income from business” under the Income Tax Act.

Answer 10

MOSTLY the same

Some distinctions:

1) ATTRIBUTION rules - only apply to income from PROPERTY
2) NON-RESIDENT INCOME from BUSINESS = taxable; non-resident income from PROPERTY -> subject to Part XIII withholding tax
3) PROVINCIAL TAX - Income from PROPERTY taxed based on province where owner resident at end of tax year; Income from BUSINESS taxed in province of permanent establishment
4) FAPI (foreign accrual property income) - definition excludes ACTIVE BUSINESS income
5) Capital cost allowance (CCA) -not allowed for RENTAL PROPERTY
6) Cumulative ELIGIBLE CAPITAL DEDUCTIONS - only available for business income
7) SMALL BUSINESS DEDUCTION and INVESTMENT INCOME REFUND - SBD only available for business income; Investment income refund available for “aggregate investment income” which excludes active business income
8) Inclusion of amount received for goods NOT DELIVERED or services NOT RENDERED is just for business income

Question 11

Explain the level of activity test for distinguishing income from business and income from property.

Answer 11

• level of activity = main distinction btwn business and property
• business = “ORGANIZED ACTIVITY”
• Income merely from OWNERSHIP (i.e. passive) = property
• Income primarily from EFFORTS of owner/employees (i.e. active) = business

Question 12

Be able to describe the concept of profit.

Answer 12

Profit is a NET concept (i.e. revenue MINUS expenses incurred to generate it)

consistent w/ policy re income as accretion to wealth

Profit is a question of LAW

Question 13

Explain how, in very general terms, “profit” been defined by the Supreme Court of Canada.

Answer 13

Profit def’d in 3 SCC cases (all involving “tenant inducement payments”)

1) question of law,
2) profit = revenues net expenses incurred to earn that revenue,

Question 14

Describe the method the taxpayer must use in determining “profit” from a business or property.

Answer 14

TP can use ANY method that provides an accurate picture of profit that is not contrary to well accepted business principles, accounting principles, case principles, or legislation

Question 15

Explain where generally accepted accounting principles fit in the determination of “profit” from business or property (a) according to the courts; and (b) practically speaking.

Answer 15

According to COURTS

• courts avoided saying to rely on GAAP -> use “well-accepted” principles instead
• Accepted business and accounting principles INCLUDE “Generally Accepted Accounting Principles” (GAAP)

PRACTICALLY speaking
- businesses use GAAP to prepare financial statements and then ADJUST them to statements for tax purposes making adjustments specifically required by the Act/case law

Question 16

Explain why courts do not want to define the starting place for the calculation of “profit” as “generally accepted accounting principles”.

Answer 16

Iaccabuci, J (in Symes and Canderel) -> Don’t want to DELEGATE the meaning of profit in the ITA to ACCOUNTANTS (who are unelected)

BECAUSE - Determination of the meaning of “profit” is a question of LAW

Question 17

Give an example of a situation in which an accepted accounting treatment differed from the tax treatment allowed by the court and explain why the court did not follow the accepted accounting treatment.

Answer 17

Anaconda America Brass v MNR (1955, Privy Council – on appeal from SCC)
• Privy Council said accepted accounting treatment NOT DETERMINATIVE -> did not follow b/c nevertheless did not provide accurate reflection of profit
• Court acknowledged accepted accounting method was VALID and MOST APPROPRIATE not determinative b/c Court has to decide whether it conforms with the ITA (which is a question of law)

Question 18

Identify three factors that identify “generally accepted” accounting principles and explain the relationship of generally accepted accounting principles to the Handbook issued by the Canadian Institute of Chartered Accountants.

Answer 18

Factors

• followed in SIGNIFICANT number of SIMILAR situations
• support in pronouncements of PROFESSIONAL ACCOUNTING BODIES
• support in writing of ACADEMICS

Handbook

• CICA sets RECOMMENDATIONS and publishes them in Handbook
• useful reference but NOT CONCLUSIVE source of GAAP

Question 19

Identify and explain five reasons for tax law deviations from generally accepted accounting principles.

Answer 19

1) GAAP VARIATION in Treatment - GAAP allows varying treatments -> tax law needs to be more consistent
2) GAAP too CONSERVATIVE - conservative accounting approach counter to revenue objective of income tax (law is less conservative)
3) Pursuit of TAX INCENTIVES - legislation has policy objectives (and gives incentives for activities)
4) CASH TO PAY the Tax - accrual method can lead to heavier burden than TP able to pay -> Act allows some revenue to not be included until received
5) Accountants DON’T want to make financial statements based on TAX CONCERNS - concern of misstatements if choice of acceptable methods based on tax considerations

Question 20

Explain the distinction between the cash method of accounting and the accrual method of accounting.

Answer 20

Cash method = revenue recognized when RECEIVED, expenses recognized when PAID (i.e. could lead to inaccurate picture of expenses year-to-year)

Accrual method = revenue recognized when RECEIVABLE, expenses recognized when PAYABLE (i.e. could be included in tax before money received/expense paid)

Question 21

Explain the matching principle under the accrual method of accounting.

Answer 21

REVENUES matched to tax PERIOD to which they relate

• ACCRUED when person has completed performance (eg
• DEFERRED to later accounting period if paid in advance (eg paid in advance for later services)

EXPENSES matched to revenue they GENERATE

• ACCRUED when costs are used up (e.g. used service before end of period, even if bill not till later)
• DEFERRED to period to which expense relates (eg insurance paid in advance)

Question 22

Indicate when the cash method of accounting may be used for the purposes of the Income Tax Act and when the accrual method of accounting must be used for the purposes of the Income Tax Act.

Answer 22

FOR BUSINESS

• s. 28 permits income from FARMING and FISHING businesses to be computed by the cash method
• Where Act is silent (ie for other businesses), can use cash method where: 1) cash method would be APPROPRIATE for that business under GAAP, and 2) cash method has been used CONSISTENTLY
• BUT ACCRUAL METHOD IS THE USUAL METHOD UNLESS ITA SAYS OTHERWISE

For OFFICE OR EMPLOYMENT
- CASH basis

For CAPITAL GAINS/LOSSES
- similar to cash basis (ie recognized when gain or loss realized)