Deducting Business Expenses Reduces Profit
Canadian business owners are able to deduct business expenses when calculating their profits for tax purposes. Claiming business expenses in their tax filings is of course advantageous because it reduces the total profit that a business made during the tax year thereby reducing tax liability. Those expenses also reduce GST/HST liability by allowing a deduction for input tax credits. However, it can sometimes be confusing to determine exactly what is a business expense and what documents (if any) are needed to deduct expenses. This article will explain what a business expense is and what documents (if any) are needed in order to claim business expenses as deductions in a given tax year.
The Starting Point of Business Expense Deductions
Subsection 9(1) of the Income Tax Act states that a taxpayer's income from business is the taxpayer's profit therefrom for the year. In order to calculate the taxpayer's profit from his or her business, expenses must be subtracted from the revenue. Thus, the word profit in subsection 9(1) is a "net" concept which presupposes business expense deductions. Therefore, the starting point of business expense deductions is subsection 9(1).
Limiting Provisions: Expense Must Be Related to the Income Earning Process in a Business
Section 18 of the Income Tax Act provides several limiting provisions in claiming business deductions. Paragraph 18(1)(a), for instance, provides a general limitation against deductibility of expenses unless "it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property." In other words, expense must be related to the income earning process within the business in order to be deductible for tax purposes. Similarly, paragraph 18(1)(h) restricts deductibility of "personal or living expenses of the taxpayer, other than travel expenses incurred by the taxpayer while away from home in the course of carrying on the taxpayer's business." When paragraph 18(1)(a) and (h) are read together, the distinction between business and personal expenses for tax purposes is clear: business expenses may be deductible, whereas personal expenses are not deductible.
However, determining whether an expense was incurred for business profit purposes or personal purposes can sometimes be difficult. Generally speaking, case law suggests that the courts will determine whether an expense is a business expense or a personal expense by focusing on the primary purpose of the expenditure. In Symes v R, a lawyer hired a nanny to take care of her children and deducted the nanny payments as business expense. The rationale for the lawyer was that the nanny payments were business expenses as without her nanny, she would not have been able to make profit from her business in the law firm. However, the Canada Revenue Agency (CRA) disallowed the business expense deduction on the basis that the expenses were inherently personal. The Supreme Court of Canada held that the deduction was properly disallowed by the CRA. The Court stated that in order to determine whether an expense should be deductible, the "objective manifestations of purpose" of the expenditure must be observed. The Court added that the "purpose is ultimately a question of fact to be decided with due regard for all the circumstances." Thus, there is no list of exhaustive questions that will determine the nature of the purpose and of the expense in question.
There are also other expense deduction limitation provisions in the Income Tax Act. Some examples include paragraph 18(1)(b), disallows the deduction of capital expense (but section 20 allows certain capital expenses to be deducted), section 67.1, which generally limits the amount of meals and entertainment expenses incurred in the course of carrying on a business activity to 50% of the amount incurred, and section 65.7, which sets out a list of illegal payments that will not be deductible.
Expense Deduction Limiting Provisions 2: Expense Must Be Reasonable
In addition to the general limiting provisions under paragraph 18(1)(a) and (h) of the Income Tax Act, section 67 also affects whether an expense is deductible or not. Section 67 states that "no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible..., except to the extent that the outlay or expense was reasonable in the circumstances." In other words, expense must be reasonable to be deductible. This provision is generally applicable to any deduction claimed for tax purposes.
Whether an expense amount is reasonable or not is a question of fact. In Gabco Ltd v Minister of National Revenue, the Exchequer Court of Canada stated that the test to determine what is reasonable in the circumstances (within the meaning of section 67) was to look at what a reasonable businessman would have contracted to pay.
Deducting Expenses Without Receipts
In order to deduct business deductions, normal business practice is to maintain organized books and records to withstand a potential CRA tax audit. Part 13.9.22 of the CRA Income Tax Audit Manual states that expenditures without supporting documents should be disallowed unless there is other satisfactory audit evidence to support the amount. It also goes on to state that reasonableness of expenses without supporting documents may be determined by using "indirect audit techniques." Thus, although having records and receipts as supporting documents for expenses would be most ideal, even the CRA manual acknowledges that supporting documents are not necessary to deduct a claim for expenses.
Indeed, the Supreme Court of Canada in Hickman Motors Ltd. v R stated that "credible oral evidence from a taxpayer is sufficient notwithstanding the absence of records" if the Income Tax Act does not explicitly require documentation. There is no statutory requirement in the Income Tax Act with respect to supporting documents that must be present to claim business expenses.
Pro Tax Tip: Maintain Organized Books and Records
If you are a business owner, you should maintain an organized books and records including invoices for every expense incurred during the course of business so that you may prove that the expense incurred was (1) related to the income earning process within the business and (2) reasonable in the circumstances. However, even if you lack supporting documents, you may still be able to claim your business expenses. If the CRA tax auditor disallows certain deductions on the basis of insufficient documents, you can retain one of our experienced Canadian tax litigation lawyers to file a notice of objection or to appeal to the Tax Court of Canada. If you have been audited by the CRA, contact our knowledgeable Toronto Tax Lawyers for professional tax advice.
