December 30th, 2020
Basic Tax Implications for Canadian Entrepreneurs
With the calendar year coming to a close and the first quarter of next year on the horizon, tax season looms large for Canadian businesses, employees, and entrepreneurs alike. It is important to distinguish the tax implications between individuals earning income from employment and self-employed individuals in an enterprising venture. This post outlines the general principles of how the tax system in Canada operates, how tax is assessed, and explores the implications for entrepreneurs operating a business in Canada.
The Source Concept of Income and Residency
The central document that determines the rules and processes behind Canadian tax is the federal Income Tax Act. According to the Act, Canada taxes income earned based on the source concept of income. Section 3 of the Income Tax Act states that the income of a taxpayer for a taxation year is determined by… “the taxpayer’s income for the year from each office, employment, business, and property”. Although there is no specific mention of when markers to use when calculating a “year”, for tax purposes, taxpayers calculate it on the calendar year.
Taxation is also based on the taxpayer’s residence. Canadian residents are taxed on world-wide income from all sources which are the office, employment, business, and property categories mentioned above. Individual persons are determined to be Canadian based on their customary mode of life, the main indicators of which are an individual’s primary ties. These include maintaining a permanent place of residence in Canada and whether or not you have a spouse or dependent(s) in Canada as well. Generally, if a taxpayer permanently lives in Canada and has a family, there is no question as to the residency, and thus tax implications for that taxpayer. As entrepreneurs are generally advised to carry on their business through a corporate vehicle, there are different ways to determine residency for corporations. For corporations, the residency test looks to whether a corporation is incorporated in Canada either federally under the Canadian Business Corporations Act, or provincially with the Alberta Business Corporations Act. Additionally, for companies operating in multiple jurisdictions, Courts will look to the test from DeBeers, which asks where the “mind and management” of the corporation resides. In other words, one must determine where the Board of Directors of that particular company sits and makes decisions from.
For our purposes, individual residency is generally not an issue as most small businesses and growth companies start locally. For corporations, an entrepreneur may incorporate in other jurisdictions in which they operate in, so the mind and management test will play a large factor in determining residency, and thus the taxpayer’s tax implications.
Income for Businesses
The general formula to apply when calculating taxes is simple. First, the resident taxpayer determines the total of all amounts each of which is the taxpayer’s income from a source, which are listed but not limited to as office (elected officials), employment, business (entrepreneurs), or property (rental). Second, the taxpayer includes any taxable capital gains, which is income derived from the disposition (sale) of property like houses and shares. Next, deductions like moving and childcare expenses are removed from the total income. Finally, the taxpayer subtracts any office, employment, business, and property losses from their total income.
A business is a profession, calling, trade, manufacture of any kind whatsoever and an adventure or concern in the nature of trade, but it does not include income from an office or employment. Section 9(1) of the ITA lays out the initial starting point. A taxpayer’s income for a taxation year from a business is the taxpayer’s profit from that business or property. However, the Act does not define what “profit” means, but common law jurisprudence indicate that profit means net profit. Net profit is equal to the total revenue of a business less any expenses incurred earning that revenue, adjusted by specific rules contained in the Act. In the jurisprudence, there are a variety of cases that ask the question whether or not the impugned activity constitutes carrying on a business, or whether the activity is deemed to be a personal endeavours. However, as one of the main points the case law examines is whether or not the activity is being done for the intent to profit, and entrepreneurs go into business to make money, that is not a point that requires much discussion.
Subsection 9(1) also contains the primary rule for business deductions through the definition of a taxpayer’s income from a business as the “profit from the business… for that year”. As mentioned, profit from the business is defined to be net profit. This is determined according to accounting or commercial principles unless the principles are overridden by other provisions of the Act or case law. Therefore, the primary rule for deductions is net accounting profit calculations, less any reasonable expenses incurred in earning income from the business.
The concept of calculating profit and deducting expenses is a general rule that is subject to specific restrictions; section 18 of the Act specifically limits a deduction for certain expenses. These restrictions have further exceptions from section 20 which serve to overrise section 18 and specifically allows a deduction of capital cost allowance. Capital cost allowance is simply the depreciation of capital property over a certain period of time. Finally, section 67 imposes a generable “reasonableness standard” on the overall computation of profit and deductions and denies a deduction of expenses that are otherwise deductible to the extent that the amount of the expense is unreasonable. Section 18(1)(a) provides that an expense is deductible to the extent that it is incurred for the purpose of earning income from a business or property. Stated colloquially by Imperial Oil, did the loss in business arise in the normal course of operations?
The case law and Act also explicitly outlines expenses that are and are not deductible. Generally, personal or living expenses are not deductible under sections 9(1) and 18(1)(a). Additionally, expenses incurred when travelling to and from work, and expenses incurred from recreational facilities and club dues are not deductible either. Some deductions like moving and childcare expenses are allowed; though not explicitly calculated in computing business income, it slots into the overall deductions framework. The rules surrounding moving expenses dictate that the deduction is limited to the income earned after the move and require the taxpayer to meet four criteria: (1) the purpose for the move must have been for work; (2) residences were actually changed; (3) the new residence must be in Canada; and (4) the new residence must be at least 40 km closer to the new work location.
Finally, many entrepreneurs and employees are working from home in light of the COVID-19 pandemic. Section 18(12) of the Act allows for the deduction of income from a home workspace, subject to approval from the Canada Revenue Agency. The CRA examines whether the spave is the individual’s principal place of business, meaning over 50% of the work occurs there, or if the space is used exclusively for the purpose of earning income from business and used on a regular and continuous basis for meeting clients, customers or patients of the individual in respect of the business. According to the CRA, there are three types of workers who may qualify; these include employees, commissioned salespeople, and self-employed workers. Deductible expenses typically include utilities such as heating and electric home maintenance and supplies. Additionally, commissioned salespeople and self-employed workers can claim property taxes and home insurance. Entrepreneurs may also claim a portion of their mortgage and capital cost allowance.
How an entrepreneur approaches their tax season has major implications for the overall viability of their business. Losses incurred from operating a business can be applied retroactively to past and future income, which allows the taxpayer to focus whatever resources they have into their venture. Due to the unique possibilities of potential businesses, the general rule does not enumerate the specific deductions an entrepreneur has to keep in mind, instead applying a reasonableness standard for expenses incurred. In order to gain a deeper analysis into the various tax implications to start-ups and growth companies, consultation with a tax specialist and professional accountant is highly recommended.
 Income Tax Act, RSC 1985, c 1 [the Act].
 Ibid at s 3(a).
 Ibid at s 2(1).
 Thomson v MNR,  SCR 209.
 Denis Lee v MNR,  TCC.
 Canada Business Corporations Act, 1985 RSC, c C-44; Business Corporations Act, 2000 RSA, c B-9.
 De Beers Consolidated Mines, Ltd v Howe,  UKHL 626.
 The Act, supra note 1 at s 3(d).
 Ibid, at s 248(1).
 Ibid, at s 9(1).
 Daley v MNR, ; Arcorp Investments Ltd v Canada, 2000 CanLII 16535 (FC).
 The Act, supra note 10.
 The Act, supra note 1 at s 18.
 The Act, supra note 1 at s 20.
 The Act, supra note 1 at s 67.
 Imperial Oil v MNR, 1947 CanLII 293 (FC).
 The Act, supra note 1 at s 18(1)(l); Henry v MNR,  SCR 155.
 The Act, supra note 1 at s 248(1).
 The Act, supra note 1 at s 18(12).
 Canada Revenue Agency, Business-use-home Expenses (February 2019), online: <https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/sole-proprietorships-partnerships/report-business-income-expenses/completing-form-t2125/business-use-home-expenses.html>.
 The Motley Fool, CRA Update: Work-From-Home COVID-19 Tax Break (July 2020), online: <https://www.fool.ca/2020/07/24/cra-update-work-from-home-covid-19-tax-break>.
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Blog posts are by students at the Business Venture Clinic. Student bios appear under each post.