Canada has one tax system for employees, and a very different – much better one – for business owners. Employees are very limited in what they can write-off. Businesses engaged in working toward or earning profits are entitled to a wide variety of legally deductible business expenses in their pursuit of that profit.
So it might seem pretty simple and straightforward: one should open a small business and join the ranks of 2.6 million Canadian entrepreneurs who enjoy the favorable tax treatment of their income streams. You don’t need to be a big guy – if you operate a legitimate home-based business with the intent to produce a profit- you can qualify for most of the same deductions as an “office-based” business.
Before we show you what your first steps should be after deciding to run a business, we want to issue a little warning: No one should ever start a home-based business for the purpose of getting new tax deductions. It won’t work. Tax deductions are the result of having a home-based business, not the reason for it. The Big Brother (Canada Revenue Agency, in this case) is watching you…
So what is a business? Surprisingly, the Canada Revenue Agency (CRA), the courts and taxpayers have been arguing a lot about what would seem to be a pretty straightforward question. The reason is simple: CRA does not want to allow a taxpayer to deduct losses year after year in a questionable enterprise. The tax department invented a concept of a “reasonable expectation of profit” (REOP). In the past, if the business could not demonstrate that it could become profitable, CRA would deny the losses. As a result of the 2002 Supreme Court of Canada decision, CRA now only considers the REOP concept if there is a personal element (or hobby) with respect to your business. Otherwise, CRA will generally no longer question whether or not you actually run a business. If, however, there is a personal or hobby element in your business, then it must be determined if your enterprise is carried on in a sufficiently commercial manner as to indicate that there would be a source of income – and therefore a business. In this case the CRA would apply the REOP test.
Let’s now review the general factors considered by CRA in assessing REOP as outlined in CRA’s Interpretation Bulletin; IT504:
- Business owner’s qualifications to run a successful enterprise
- Time devoted to the business
- Time spent in marketing goods and services of the enterprise
- Distribution activities: presentation of works, products, services to the public
- Revenues received and growth of revenues taking into account economic conditions and other market changes
- Historical records of profits
- Type of expenses claimed and their relevance to the business.
Next important question is: “When does the business start?” The answer is simple: in order for any amount to be deductible on a tax return, the taxpayer must “carry on business” in the fiscal period in which the expense has incurred. Here are some guidelines from CRA’s Interpretation Bulletin; IT 364:
- A business starts whenever some significant activity that forms a regular part of the income-earning process takes place.
- There must be a specific concept of the type of business activity that will be carried on.
- An organizational structure must be in place to undertake the essential preliminaries, to show whether this is a one-time transaction, or an on-going enterprise.
- Undertook market surveys to establish the place or method of carrying on a business.
- Purchased materials/inventory for resale or production,
- Began construction of a building, together with recruiting and training staff, advertising, etc.
- Negotiated contracts with future suppliers and so on.
- Therefore according to CRA the business has started if the taxpayer:
Statistically business failure rates are highest in the first two years. Normally, you as a business owner must spend both time and money before reaping any significant awards. Unfortunately, at the beginning many new businesses incur operating losses, and such losses realized in a year must be deducted in full against your other sources of income. Therefore you end up paying less income tax.
And that’s exactly where you start playing a ball game with the CRA. If you show business losses year after year CRA’s auditors might try to question the viability of your business. And remember: no business – no deductions, which means that all your legitimate business deductions will be disallowed. Pure and simple. CRA’s argument would be that your intent was to create a business loss to recover taxes paid on your employment or investment income. Don’t forget – it’s YOU who have to proof that you are NOT abusing the system.
So what steps should every business owner take to avoid this trap? First of all, BECOME a business. As we mentioned earlier, a business is an activity with a reasonable expectation of making a profit. If you are engaged in activities designed to earn money, then you are a business. You do not have to be registered to be a business; you just have to be doing the things that businesses do. Remember: the better you practice business skills the less money will go to the tax department thus improving your bottom line. Fair enough? So here are those steps:
Write a business plan.
This is not only an important business tool, your roadmap, but it will help you prove that there is a reasonable expectation of profit from your venture. “If you fail to plan, you plan to fail” – I am sure you have heard it before…
Register your business.
It is not mandatory, but highly recommended. In many cases, businesses start as sole proprietorships or partnerships. Incorporating your business can save you thousands of dollars a year. But under the wrong circumstances it will only cost you money and administrative headaches. To know when to incorporate from a taxation point of view, ask yourself a simple question: “Can I leave some of my company’s profits in the business, thus deferring income?” If the answer is yes, then consider incorporating your venture.
Open a separate business bank account
In case your business is not registered, just open a separate chequing account and designate it as your “business” one. Never co-mingle personal and business funds. In this way you will keep your personal and commercial activities clearly separated. Same rule applies for a credit card account.
Start a Daily Business Journal
This is a simple and inexpensive way to prove that your business has started and has a reasonable expectation of profit in the future. Keep a detailed record of all the activities you performed in the past to get to that “profitability” point. Try to conduct those activities on a regular basis and in a business-like manner. Remember – you should be able to prove that this is NOT your hobby.
Start an Auto Log
In case you use your car for business (and most entrepreneurs do) you need to keep the record of your business-related trips. This is one of the CRA’s requirements, and I can guarantee you that every CRA auditor would like to see those records. Auto Log is a simple and traditional method of keeping them. Personally I use an Excel spreadsheet but auto log books are readily available in most business stores. Every entry should contain the date, purpose of the trip and odometer readings (at the start and end of the trip). Sounds like a piece of cake, but surprisingly an absolute majority of small business owners don’t bother to keep auto logs therefore losing this round of a Tax Game to the CRA. Go figure…
You might also want to seek professional help from one of our Tax Coaches.
By Pavel Tishchevskiy
This article is written by Pavel Tishchevskiy, a founder of 777 Taxes Inc., the company pioneering the concept of Tax Coaching for Canadian small business owners. He is the author of numerous articles on financial topics and he also runs seminars and workshops on taxation issues. Pavel Tishchevskiy offers a free one-hour tax consulting meeting to our readers; he can be reached at email@example.com or by phone 416-857-7570. You can also check the website www.777Taxes.com for more details.