For Canadian income tax purposes, all deductions for expenses must be "reasonable in the circumstances" under section 67 of the Income Tax Act (Canada). The recent decision from the Federal Court of Appeal (the "FCA") Peach v. Canada, 2022 FCA 163 illuminates what it means for an expense not to be reasonable, and rejects questioning a taxpayer's business judgment in this exercise. Mr. Peach (the taxpayer in the decision) owned several rental properties that were rented to his three sons, and he sold life insurance and mutual funds to a client base largely consisting of friends and family. Mr. Peach claimed business losses during his 2011 taxation year for the operation of the properties and the financial services business. During the 2011 year, Mr. Peach transferred one of the rental properties to one of his sons but did not report either this disposition nor any associated capital gain or loss in his income tax return. Moreover, also during the 2011 taxation year, the taxpayer earned only $27 in revenue from his life insurance business, but claimed over $19,600 of business expenses for said business.1

In issuing the reassessment of Mr. Peach's income, the Minister of National Revenue removed all rental revenue and losses associated with his rental properties, reduced the amount of business expenses he claimed for his business, and included a capital gain on the transfer of the rental property to his son. The taxpayer appealed the reassessment to the Tax Court of Canada (the "Tax Court"),2 and the Tax Court reduced Mr. Peach's capital gain on the transfer of the rental property, but otherwise upheld the Minister's assessment. The taxpayer appealed to the FCA.

A notable factor in the decision was that Mr. Peach's rental activity involved significant personal components and Mr. Peach was not pursuing a profit, so the rentals did not constitute a source of income as described in Stewart v. Canada, 2002 SCC 46 ("Stewart"). As stated by the FCA, "all three of the appellant's tenants had been his sons, and ... the appellant had set the properties' rental rates below market value".3 We invite you to read our earlier  post for further details on Stewart  and the source concept of income in Canadian income tax.

The Tax Court and the FCA also made interesting comments respecting what constitutes a reasonable expense. The courts could not have been more clear that, as suggested by the taxpayer, "the Tax Court's role is not to evaluate a taxpayer's business acumen".4 However, Mr. Peach's expenses were not reasonable. The Tax Court held that "no commercially-minded business person would continue to incur expenses in the amounts Mr. Peach claims to have done year after year, were such business person in Mr. Peach's circumstances".5

There is an apparent contradiction in these conclusions: how is it that the courts can avoid challenging a taxpayer's business acumen while finding that Mr. Peach's expenses were unreasonable? The broader context of the case and a consideration of prior jurisprudence unravels this contradiction.

As mentioned, Mr. Peach's life insurance business customers consisted largely of friends and family.6 In addition, the business operated over ten years without making any profit.7 Finally, the taxpayer reported over $19,600 in business expenses without generating any opportunities or new clients,8 and while earning only $27 in revenue.9 The taxpayer argued that "his poor business judgment" could not be used to prevent him from deducting expenses from his income, and he relied on the decision Keeping v. Canada, 2001 FCA 182 ("Keeping") for this proposition.10 However, in the Keeping  decision the "Court was not being asked to base its decision on any personal benefit that may have accrued to the appellant".11 This is a major factual departure from the facts of the Peach decision, where no element of the case was free from Mr. Peach's personal or family interests.

The Tax Court and FCA accepted that Keeping  continues to be good law for not questioning a taxpayer's business acumen when determining whether an expense is reasonable12 and dismissed the taxpayer's appeal. There can be no doubt that the outcome of the Peach  decision was materially determined by the personal elements to Mr. Peach's activities.13

The decision in Peach therefore represents a continuation of a long and consistent line of jurisprudence that rejects the second-guessing of a taxpayer's business judgment.14 Although the earlier decisions in this line of jurisprudence refer to the now rarely used "reasonable expectation of profit" test, in doing away with the "reasonable expectation of profit" test15, the Supreme Court of Canada in Stewart was primarily concerned with situations where there is no personal or hobby element.16 The Supreme Court of Canada in Stewart agrees that courts are not to evaluate a taxpayer's business acumen.17

Footnotes

Peach v. Canada, 2022 FCA 163 ("Peach") para 2. This decision is only the latest in a series of related decisions for the same taxpayer in prior taxation years, including 2013-4425(IT)I, Oral Reasons delivered September 9, 2014, aff'd in part at 2016 FCA 173 and redetermination of certain issues at 2017 TCC 40.

2 2020 TCC 12.

Peach, para 21.

Peach, para 23.

5 2020 TCC 12 at para 49.

Peach, para 2.

Peach, para 22.

Peach, para 22.

Peach, para 2.

10 Peach, para 23.

11 Keeping, para 3.

12 Peach, para 23.

13 See 2022 TCC 12 at paras 38 (Tax Court's general comment on expenses), 42 (meal expenses), and 44-45 (travel expenses). The Tax Court and FCA consideration of Mr. Peach's automobile and office expenditures should be considered in this context. See also Brown,  2022 FCA 200 at paras 20 to 232, where the FCA distinguishes between a personal motivation and a personal element of an activity.

14 See e.g.Mastri, [1997] 3 CTC 234 [FCA], Tonn, [1996] 1 CTC 205 [FCA] and Bélec, [1995] 1 C.T.C. 2809

15 See Paletta, 2022 FCA 86 at para 34.

16 Stewart, para 53.

17 Stewart, para 55.

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