Business Losses and the Pursuit of Profit
May 2019 the Federal Court of Appeal heard an appeal from an Ontario lawyer who operated a private law practice on a part time basis in addition to her full time employment with the Government of Canada. This is a common situation in Canada and we often see people working full time that set up 'side businesses'. Sometimes the intent is to start a business, build it up, make big profits and retire. Other times the intent is to write off otherwise non-deductible or personal expenses to create a business loss which can be applied against their employment income creating a 'tax refund'. A cautionary tale follows.
Ms. Renaud began working for the Government of Canada in 2000 and moved to the Ottawa region at that time. Prior to 2000, she ran her own full time law practice in Repentigny, but reduced her hours after taking on the new position.
From the years 2001 to 2014, she claimed business losses every year, ranging from $1,956 in 2003 to $15,680 in 2012. In addition to the losses, her gross billings were quite low with her maximum gross income reported in a year was $3,850. In three of those years (2005, 2009, and 2010), she reported no gross income.
At issue were the years 2011, 2012, 2013, and 2014. In those years she reported gross income of $2,500, $850, $850, and $3,850 respectively. Her losses for those four years were $12,613, $15,680, $4,014, and $6,662 respectively.
Ms. Renaud made assertions that she spent on average about 5 to 10 hours working in her private practice per week. She did not take on more work than she had time available and made sure there were no conflicts with her full-time job.
Her practice was varied; she practices family, civil, administrative and criminal law. She does consultations, gives legal advice and participates in negotiations.
Some of her answers to questions were vague. When asked how many clients she had or how many cases she handled, her answers were not very specific.
Ms. Renaud testified that she does not work on a volunteer or pro bono basis. She does, however, adjust her rates based somewhat on a client's ability to pay. She also testified that she does not advertise as she receives enough clients from word of mouth.
The issue in this case was whether Ms. Renaud had a 'source of income'. CRA didn't challenge the legitimacy of her expenses but challenged whether or not she actually was operating a business. If they can prove she didn't have a business, they could deny her losses.
To determine whether she had a 'source of income', the court turns to the Supreme Court of Canada and the 2002 case Stewart v. Canada. In this case, the Supreme Court determined a two-step process for determining if a 'source of income' exists. The first step equates 'Source of income' with an activity undertaken 'in pursuit of profit', which is consistent with the traditional common law definition of 'business'.
After considering the facts of the case, the judge stated that the practice "is quite simply not undertaken in pursuit of profit." He came to this conclusion partly by looking at the hours worked by the appellant. She claimed to work an average of 5 to 10 hours per week. At 50 weeks per year, the judge concluded she worked at most 500 hours per year. In the four years at issue, she billed $2,500, $850, $850 and $3,850 respectively. This works out to $5 per hour in the first year, $1.70 per hour in the second and third, and $7.70 per hour in the fourth year for each hour worked. He stated "This is not at all like a law practice as normally understood, even in the wildest sense."
Further, the judge pointed out that Ms. Renaud made no mention of cases that could be highly profitable later on and no evidence was provided to show Ms. Renaud sought to change her billing practices or make changes to her client base to increase income.
So if you are in a similar position to Ms. Renaud where you are operating a small business with multiple years of losses and deducting those losses from other sources of income, you may want to consider whether you have a 'source of income' and are operating 'in pursuit of profit'. If not, you should be aware that CRA can simply wipe out your losses for tax years that are not statuted barred.