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

Chapter 4

Income from Business:

General Concepts and Rules

1

Business Income

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

2

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”

3

Steps to Addressing Income vs. Capital Gain Issue

1. Gather all the facts leading up to, during, and after the transaction.

2. 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.

3. Analyze the strengths and weaknesses of your arguments.

4. Arrive at a conclusion of income or capital gain consistent with your analysis.

5. Determine how the transaction will be taxed if the taxpayer is:

a. an individual, or

b. a corporation.

4

Exhibit 4-1

5

Income vs. Capital

• Damages– Non-performance of business contract– Cancellation of agency agreements– Loss of property

7

Other Receipts or Benefits

• Profits from an illegal business

• Profits from betting, gambling, and windfalls

• Subsidies

• Forgiveness of debt rules

8

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.

9

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?

10

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

11

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

12

Sole Proprietorship

• Generally, must report on a calendar basis

• Election available for alternative fiscal year but additional rules for reporting business income apply

13

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 purposes14

Inclusions in Income for Tax PurposesITA 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)

15

Inclusions

• Amounts received or receivable

• Inducement payments or reimbursements

• Restrictive covenants

• Partnership income

• Barter transactions

16

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.

17

Summary of DeductionsSpecifically 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

18


Sec. 18ITA 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 loss19


Sec. 67ITA 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

20

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

21

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

22

Reasonable Expectation of Profit(REOP)

Checklist for evidence REOP:1. Manner in which activity is operated

2. Elements of personal pleasure or recreation

3. Expertise of the taxpayer or his/her advisers

4. History of income and loss

5. Time and effect expended

6. Financial status of taxpayer

7. Amount of occasional profits

8. Sale or discontinuance of activity

9. Success of taxpayer in other activities

10. Expected appreciation of asset value

23

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

24

Deductions Specifically PermittedSec. 20


Related References

20(1)(a) Capital cost allowance 18(1)(b)

20(1)(b) Cumulative eligible capital amount 18(1)(b)

20(1)(c), (d) Interest IT-533

20(1)(e) Expenses of issues shares or borrowing money

18(1)(b)

20(1)(e.2) Premiums on life insurance used ascollateral

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

25

Deductions Specifically PermittedSec. 20


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 18(1)(b)

20(1)(dd) Investigation of site 18(1)(b)

20(1)(ee) Utilities service connection 18(1)(b)

20(1)(qq), (rr) Disability-related modifications and equipment

18(1)(b)

20(10) Convention expenses

26

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

27

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.

28

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:i. 18% of employee’s employment income under sections

5 and 6

ii. A specified dollar limit as follows:

2010 2011 2012 2013 2014

$22,450 $22,970 $23,820 $24,270 Indexed

29

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:i. ½ of the money purchase dollar limit for the year;

and

ii. 18% of the employee’s compensation for the year.

30

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 31

Sales/Negotiating Person’s ExpensesOrdinary 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 NoneCommission

incomeNone None

32

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

33

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

34

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 . . .”

35

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

36

SR&ED Pool

Deducted againstIncome when needed

SR&ED Pool

Current SR&EDExpendituresLess: ITC claimedIn previous pool

Capital SR&EDExpenditures made before 2014Less: ITC claimedIn previous year

37

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

38

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

39


• Commercial Activity– Value for tax– When GST/HST is payable– Automobile operating cost benefits paid by

employer

40


• 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

41


• Adjustments to Net Tax– Excess charges– Price reductions– Bad debts– Lease of passenger vehicles– Food, beverages, and entertainment expenses

42

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

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