On the 1st of August, 2012, the Supreme Court of Canada ("SCC") delivered its decision in the case of Canada v Craig1 in which it revisited the interpretation of section 31 of the Income Tax Act 2 ("ITA"). The question to be decided by the SCC was under what circumstances the combination of farming and some other source of income constitutes a "chief source of income", allowing a taxpayer to avoid the farming loss deduction limit of section 31.
Where farming is a source of income for a taxpayer, section 31 of the ITA may apply to limit the amount of loss from farming that can be deducted from the taxpayer's other income. Section 31(1)(a) provides that, where a taxpayer's chief source of income is neither farming nor a combination of farming and some other source of income, the taxpayer's deductible farm loss is limited to $8,750 annually.
In Moldowan v The Queen 3 , the SCC found that the predecessor of section 31 provided for three classes of taxpayers involved in farming. In the first class are taxpayers for whom farming provides the bulk of their income or is the centre of their work routine. Loss deductions are not limited for the first class. In the second are taxpayers who don't look to farming, or to farming and some subordinate source of income, for their livelihood but carry on farming as a sideline business. For this class, subsection 31(1) limits the possible loss deductions. The third class consists of taxpayers who carry on some farming activities as a hobby, not as a business, and whose losses are not deductible in any amount.
Following the decision and for the three decades that followed, there has been criticism from the judiciary, academics and members of the legal profession over the description of the second class of taxpayers. Those taxpayers were subject to the loss deduction limit because the description implied that for the limitation not to apply, farming must be the chief source of income, the same as for a taxpayer in the first class.
However, section 31 provides two distinct exceptions to the loss deduction limitation. One is where farming is the taxpayer's chief source of income. The second is where the taxpayer's chief source of income is a combination of farming and some other source of income. By requiring that the second exception apply only where the other source of income was subordinate to the farming source of income, Moldowan collapsed the second exception into the first.
In the case of the appellant John H. Craig, his primary source of income came from his law practice. He also had farming income from buying, selling, training and maintaining horses for racing. He suffered considerable losses from his horse-racing business in 2000 and 2001 and deducted those losses against his other income. Pursuant to the interpretation of section 31 in Moldowan, the Minister reassessed the appellant, limiting the deductible losses for each year to $8,750, on the basis that the combination of his law practice and his horse-racing business was not his chief source of income since his horse-racing business was a subordinate or sideline business.
During the appeal, the SCC recognized its inherent power to overrule its own decisions. To overrule, the Court must be satisfied based on compelling reasons that the precedent was wrongly decided. In making this decision the SCC engages in a balancing exercise between the two important values of correctness and certainty. The Court must ask whether it is preferable to adhere to an incorrect precedent to maintain certainty, or to correct the error. In the case of Craig, the SCC held that the Moldowan approach to the combination question was incorrect and found it appropriate to revisit the interpretation of section 31.
According to the SCC, unexpressed legislative intention under the guise of purposive interpretation is to be avoided. In the case of section 31, it is clear that two distinct exceptions to the loss deduction limitation can be identified and a judge-made rule that reads one of the exceptions out of the provision is not consistent with the words used by Parliament.
However, the Court stated that a simple aggregation of income from two sources cannot have been contemplated by the section, meaning that factors other than two sources of income should be taken into account. Taking a contextual approach, the relevant factors to consider according to the Court are the capital invested in farming and the second source of income; the income from each of the two sources of income; the time spent on the two sources of income; and the taxpayer's ordinary mode of living, farming history, and future intentions and expectations. Both endeavours must be significant endeavours of the taxpayer, but they do not need to be connected, and farming does not need to be the predominant source of income. The question is whether, looking at these factors together, the taxpayer places significant emphasis on each of the farming business and other earning activity, and if so, the combination will constitute a chief source of income and avoid the loss deduction limitation of subsection 31(1).
During the trial, the Crown conceded that Mr. Craig's horse-racing operation was a business, not a personal endeavour, and the relevant factors, other than demonstrated profitability, clearly pointed to it being more than a sideline business. Even though Mr. Craig derived his principal income from the practice of law and the total hours spent at his law practice exceeded the time spent on his farming business, he devoted both a material amount of capital and a very significant part of his daily work routine to the farming business. The court also gave weight to the fact that Mr. Craig was an active member of and contributor to the community of standard-bred racing. Therefore, the SCC agreed with the trial judge in holding that farming, in combination with Craig's law practice, was a chief source of income, and that the loss deduction limitation in subsection 31(1) did not apply.
The SCC in Craig overturned an incorrect precedent and opted for a more flexible approach. However, courts will still encounter cases pertaining to section 31, as the determination of what constitutes a taxpayer's chief source of income is a factual one for the trial judge and rests on the weighing of multiple factors as well as case specific circumstances.
Footnotes
1 2012 SCC 43.
2 RSC 1985,c 1(5th Supp).
3 [1978] 1 SCR 480.
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