The tax treatment of income varies dependent on the type of income. To file tax returns correctly and tax plan appropriately it is vital for taxpayers to understand which type of income they are earning. However, the dividing line between different classifications of income is not always clear and often requires interpretation by an experienced Canadian tax lawyer. This is particularly true as it pertains to capital income and business income. Business income is income earned "from a profession, a trade, a manufacture or undertaking of any kind, an adventure or concern in the nature of trade or any other activity [the taxpayer carries] on for profit". Income earned on the sale of property is classified as capital income, which may also be called investment income, property income or capital gains/losses.
To explain why this classification can be difficult, consider the following example:
- There are two taxpayers. Taxpayer A who does not work in the real estate industry sells the house she's owned for 20 years after her marriage dissolves. She earns capital income on this sale. Taxpayer B is a house flipper earning business income on the sale of property he renovates and sells. In 2019, Taxpayer B decides to sell the home he just finished renovating for himself and his family when his wife gets a new job. Is this business income? The taxpayer has made a business of flipping and selling homes. He has effectively flipped and sold this home. Is this capital income? This house was intended as his family home unlike his other properties he sold to earn a profit. For a third party, like the Canada Revenue Agency, observing Taxpayer B's activities, it will be difficult to classify this income which has signifiers of both business and capital income.
Tax Treatment of Business Income vs. Capital Income
Business income and capital income receive different tax treatment under the Income Tax Act. Business income is fully taxable. Business losses are deductible against non-capital income. Those losses earned after 2005 can be carried forward 20 years and back three years (i.e. a business loss earned in 2018 can offset income earned between 2015 and 2038). Taxpayers may additionally be able to claim certain business expenses to decrease their business income. Conversely, only 50 percent of capital gains and losses are taxable or deductible, respectively. Capital losses can only be deducted from capital gains. These losses can be carried forward indefinitely and back three years. In certain circumstances the lifetime capital gains exemption can be applied to reduce capital income.
Test to Determine Income Classification
The test to determine whether particular income is classified as business or capital income was developed in the leading case Happy Valley Farms Ltd. v. Her Majesty the Queen. The test contains six elements. None of these elements are determinative on their own and must be considered together with the overall conduct and circumstances of the taxpayer. The six factors are as follows:
- The nature of the property sold: Certain types of property are more likely to result in capital income or business income. For example, shares generally result in capital income, though business income can be earned from selling shares as well. Other property, like certain real estate, are neutral. Generally, property which gives the owner a return that is either financial or personal enjoyment simply by owning the property will give rise to capital income upon its sale.
- The length of period of ownership: Shorter periods of ownership suggest business income is being earned. Nevertheless, the courts have considered whether shorter periods of ownership are appropriate given the circumstances and thus not indicative of business income.
- The frequency or number of similar transactions by the taxpayer: A taxpayer who has a pattern of making similar sales or makes several similar sales around the same date is generally conducting business.
- Work expended on or in connection with the property realized: Those conducting business are typically actively looking to sell their property and will expend work to make the property marketable or find purchasers. This factor can often be analyzed by comparing the taxpayer's activities to those of a person conducting business with the same property.
- The circumstances that were responsible for the sale of the property: Reasons for the sale of property which are unexpected at the time of purchase, such as job loss, are indicative of capital income.
- Motive: The taxpayer's intention, to conduct business or earn capital income, at the time of acquiring the property.
All of these factors are geared towards deriving the intention of the taxpayer with respect to the sale of the property from the taxpayer's conduct and surrounding circumstances. A taxpayer who intends to earn business income and acts accordingly should be found under this test to earn business income.
The Court in Happy Valley Farms did acknowledge the possibility of "secondary intention". A secondary intention is found where, at the time the property was purchased, part of the taxpayer's motivation for the purchase was the possibility of resale for profit even though the taxpayer's main intention was investment. Where a secondary intention is found, the sale can be taxed as business income.
Tax Tips – The Importance of Understanding the Classification of Your Income
Whether a particular taxpayer prefers to earn business income or capital income will depend on the taxpayer's particular situation. Although one taxpayer could find maximizing the amount of losses available to them by claiming business losses beneficial, while another may want to reduce their taxable income by claiming capital income, generally speaking taxpayers would prefer to earn capital gains rather than business income. Furthermore, it is important the taxpayer's classification of their income accurately reflects their intentions and conduct. The classification of income as business income or capital income is highly fact specific. Appropriate income tax planning can also help steer income into the appropriate categorization. Our top Canadian tax lawyers can help you with tax planning and also analyze your situation to identify the beneficial and accurate classification of your income to assure appropriate income tax filings.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.