Losses Incurred as Part of a Personal Endeavour vs. in Pursuit of Profit

written on behalf of Feigenbaum Law

For many new business startups, the first few years can be tough. If a business is lucky, it can make it through those lean years and eventually grow into a successful operation. It’s not uncommon for people who start a small business to expect to make little to no income in these early years. However, a recent decision from the Tax Court of Canada shows that losses incurred due to a struggling family business might not necessarily result in loss deductions for personal income tax purposes.

A Family-Run Art Gallery

The issue concerned a taxpayer whose wife opened an art gallery in Toronto in April 2010. At first, the taxpayer (who had a full-time career unrelated to the business) did not provide any extensive services to the gallery but did offer some managerial and administrative services.

Unfortunately, in 2010 the taxpayer’s wife became ill and was unable to run the gallery, which only had one other employee. In addition, the couple became pregnant with a child, which further limited the wife’s ability to contribute to the operation of the gallery. As a result, the taxpayer took on a more active role in the day-to-day operations of the gallery.

Unfortunately, the gallery was not financially successful in these early years, with losses totalling $108,000 in 2010, the first year of operation.

Entering Into a Formal Services Agreement 

At the start of 2011, the taxpayer suggested to his wife that he enter into an agreement with the gallery to provide a range of services related to the day-to-day operation of the gallery. Rather than receiving a traditional salary or hourly remuneration for his services, the agreement stated that he would receive an annual management fee equal to 20% of the gallery’s annual revenue in excess of $100,000.

The gallery’s financial losses continued through the next few years, leading the taxpayer to report annual business expenses and losses ranging between $90,000-$115,000, depending on the year. The taxpayer stated he incurred these losses in order to provide services to the gallery. However, the Minister of National Revenue disallowed his losses on the basis that they did not come from a business source as defined by the Income Tax Act. The Minister found that since he could not have reasonably expected to make a profit from the activities due to the terms of the agreement, the losses were not incurred for the purpose of gaining or producing income. Additionally, the expenses were unrelated to the business for which they were claimed.

Appealing the Minister of National Revenue’s Decision

The taxpayer appealed the decision, though he did concede that his losses claimed for 2011 and 2012 should be reduced to approximately half of his original claim. In deciding the matter, the Tax Court of Canada considered s. 18(1) of the Income Tax Act, which states:

18 (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of

(a) an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property;

The question came down to whether the expenses were incurred as part of a personal endeavour or in the pursuit of profit. If the expenses could not be said to have been in the pursuit of profit, the taxpayer could not claim the losses against his personal income taxes.

Were the Business Expenses Legitimate?

The court stated that it was clear there was a personal element to the business activities the taxpayer took on for the gallery, and that he would not have taken them on at all if it weren’t for the health issues experienced by his wife.

Having found a personal element, the court had to then ask if the services were provided in a sufficiently commercial manner for the services to constitute a source of business income. The court found that based on the evidence, the taxpayer did not establish on the balance of probability that his intention was to make a profit. This finding was partially based on the payment terms established for his services, which included a percentage of the gallery’s earnings, which the taxpayer knew was operating at a significant loss. Given the lack of profitability in the first year of operation, it was unlikely he would have earned a fee at all in the subsequent three years.

Ultimately, the court found the business activity was in part a personal activity. In addition, the taxpayer did not operate in a sufficiently commercial manner in order to constitute the activity as a source of business.

If you are facing a tax controversy issue, contact us for superior representation. Our team of experienced accountants and lawyers will take the time to understand the details of your case and create a nuanced plan to achieve results. We offer services to clients in the US, Canada and around the world. Contact us online to learn more about how we can help or call us at (416) 777-8433 or toll-free at (877) 275-4792.