Court Rules Against Revenue Canada
One of Revenue Canada's big hammers, the "reasonable expectation of profit" test, has been struck down by the Court insofar as broad application is concerned. The Federal Court of Appeal in the recent decision of Tonn et al v. The Queen has clearly indicated that in a normal commercial venture the reasonable expectation of profit test is inapplicable. The Tonn decision involved real estate purchased for rental income and possible capital appreciation. It was not acquired for any personal use.
Restrictions on Test
The Court said that the reasonable expectation of profit test should not be used where the activity lacks any element of personal benefit and where the activity cannot be classified as a hobby. In other words, where the activity is operated in a commercial fashion and not as a veiled form of personal recreation the test is inapplicable. The Court said "...when circum-stances do not admit of any suspicions that a business loss was made for a personal or non-business motive, the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgement may have been less than competent."
Hobby and Personal Benefits
It is important to realize that the reasonable expectation of profit test is not completely dead. In cases where the business has an element of hobby or personal benefit, the Court is saying that Revenue Canada may still apply the test.
Hobby and personal benefits cases include horse farms, Hawaii and Florida condominium rentals, ski chalet rentals, yacht operations, dog kennel operations and similar types of endeavours. These are all cases where the taxpayer has invested money into an activity from which the taxpayer derives personal satisfaction or psycho-logical benefit.
The other area in which the reasonable expectation of profit test may still be applicable is where there are "inappropriate reductions in tax". An example of this given by the Judge is where a commercial enterprise is operated at a loss in order to generate tax refunds or other such tax consequences.
It is important to note that this aspect of the judgement is not necessarily binding. The situation of a tax-motivated transaction is the Judge's opinion of the correct rule to apply. But since a tax-motivated transaction was not before the Court of Appeal that part of the judgment would not have to be followed by a lower Court.
That is not to say that taxpayers or their advisors should ignore the opinion since it is clear that Revenue Canada will be applying the test to tax-motivated transactions. Rather, taxpayers should try not to be too aggressive and ensure that there is some business reality behind any transactions which they enter into, even if there is also some tax motivation for the transaction.
"This article provides information of a general nature only. It may no longer be current. It does not provide legal advice nor should it be relied upon. If you have specific legal questions you should consult a lawyer."