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Recent court rulings can lead to big tax savings

Although my wife, Carolyn, may not realize it, she's quite privileged to have the opportunity to learn all kinds of Canadian tax lingo. The other day I thought I'd give her a test.

"Carolyn, what does T4 mean?" I asked.

"Tim, that was my apartment number in university," she replied.

"Okay, what's an RRSP?" I asked.

"That's easy," she said, "it's what I did in response to that wedding invitation last month."

"Okay. What is a reasonable expectation of profit?"

"I have no idea," Carolyn confessed.

"Carolyn, it's what I hope for every time you go out to that new interior design store downtown. You know, I hope there will be some profit still sitting in our bank account when you get home," I explained.

When it comes to tax lingo, the phrase "reasonable expectation of profit" (REOP) is one we've heard all too often in recent years. The fact is, the Canada Customs and Revenue Agency (CCRA) and the courts have too often used the REOP test to disallow business and rental losses claimed by taxpayers. Thanks to the Supreme Court of Canada, things are changing for the better.
The court decisions

Brian Stewart is not unlike many Canadians. He saw the value in buying rental real estate a few years ago. In 1986 he purchased four condo units on a highly leveraged basis when he put just $1,000 down on each unit. Mr. Stewart's actual rental losses were worse than he had projected because of his steep interest costs, and his losses for 1990, 1991, and 1992 combined were in excess of $58,000. The taxman was not impressed, and denied his losses on the basis that he had no REOP. However, on May 23, the Supreme Court of Canada sided with Mr. Stewart.

You see, the Supreme Court recognized that Canadian tax law will allow deductions (interest expense in this case) where a source of business or property income exists. The two critical issues in the Stewart case were: (1) whether a source of income existed, and (2) whether the REOP test is appropriate to determine whether or not a source of income exists.

The court decided that if an endeavour is clearly commercial in nature, with no personal element to it, then a source of income exists. This is not to say that the endeavour must produce a profit in any year.

Where an endeavour is commercial in nature, there's no room to apply the REOP test to disallow losses. In the case of Mr. Stewart, his condos were clearly a commercial endeavour. He didn't live in those condos; he rented them out. The REOP test should not have been applied to deny his losses.

Now, where an endeavour has some personal element to it (such as when you partly rent out and partly live in a property or run a business akin to a hobby), a source of income may still be considered to exist where your behaviour suggests that there is a "sufficient degree of commerciality." That is, when it's clear your intent is to generate a profit. In this case, the taxman can apply the REOP test as just one of many factors to determine whether or not the activity is sufficiently commercial in nature.

In addition to the Stewart case, the Supreme Court rendered a decision on the same day in the case Walls v. Canada in which a number of taxpayers had claimed losses from a limited partnership investment. Those losses were allowed under the same principles found in the Stewart case.
The implications

What does all of this mean?

A primary motivation to avoid tax does not affect the validity of a transaction for tax purposes. As long as an endeavour is commercial in nature (in pursuit of profit), your deductible expenses should be allowed -- even if they exceed your income.

If you're currently disputing with the CCRA over losses you've claimed in a commercial endeavour, you stand a good chance at winning the dispute.

If you've suffered through losses denied in the past, you may still have time to file a notice of objection to oppose this denial. Speak to a tax pro about it.

Even if it's too late to file a notice of objection, consider writing the CCRA to ask for a reassessment allowing your losses based on the Stewart and Walls cases if your tax year is not yet statute barred (which takes place three years after the date on your notice of assessment).

Carolyn will be glad that the term REOP is just one fewer tax term that she'll have to listen to around our house going forward.
Tim Cestnick, CA, CFP, TEP is author of Winning the Tax Game 2002 and Winning the Estate Planning Game. He is managing director, Tax Smart Services, at AIC Ltd.
tcestnick@aic.com



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