Principal Issues: [TaxInterpretations translation] In a particular situation with three scenarios:
1. Can a business's losses be disallowed on the basis that there is no reasonable expectation of profit?
2. Are amounts paid by a corporation to another arm's length corporation to carry on a business at a loss deductible?
3. Would the answer to 2. be the same if the other corporation was a corporation with which the paying corporation was not dealing at arm's length?
Position: Questions of fact. General comments only.
Reasons: 1. Following the decision in Brian J. Stewart v. The Queen, the "reasonable expectation of profit" test should not be accepted as the applicable test where the activity in question does not involve a personal aspect.
2. and 3. According to the principles set out in Canada Starch Co Ltd v MNR, a payment made to preserve a business does not create assets.
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2010-037246
I. Landry, M. Fisc.
September 28, 2010
Dear Sir,
Subject: Carrying on a business at a loss
This is in response to your letter of June 22, 2010, in which you requested our comments on various scenarios for carrying on a business at a loss in the following situation (the Particular Situation).
Unless otherwise indicated, all statutory references herein are to the provisions of the Income Tax Act (the "Act").
Particular Situation
An individual who is a member of the Ordre des pharmaciens du Québec derives income from a business in Quebec that is a pharmacy. The business in question has two departments: the dispensary department (drugs and prescription products); and the commercial department (other products). You tell us that these two divisions are part of a single business.
The individual's net income from this business has averaged $XXXXXXXXXX in recent years. You tell us that, on an annual basis, the commercial department of the business generates approximately $XXXXXXXXXX of loss while the dispensary department generates approximately $XXXXXXXXXX of income. However, you added that the fact that the individual maintains the commercial department has the effect of considerably increasing the revenues generated by the dispensary department.
The individual proposes to incorporate a new corporation ("Pharmaco") and transfer his business to it. However, under the Pharmacy Regulations, c. P-10, r. 20.1, the dispensary department cannot be operated by the same corporation operating the commercial department. In order to continue to operate both departments of his business, the individual contemplates one of the following three scenarios. In all three scenarios, the individual would first transfer part of his business (the dispensary department) to Pharmaco and then proceed with other transactions.
Scenario 1
In this first scenario, the individual continues to personally carry on the other part of his business (the commercial department). Each year, Pharmaco pays the individual a dividend in an amount equal to or greater than the amount of the loss incurred in carrying on the business (the commercial department).
You wish to know whether in this scenario the individual's business loss (commercial department) would be deductible in computing the individual's income pursuant to paragraph 3(b). In particular, you wish to know whether the Canada Revenue Agency ("CRA") could deny the loss on the basis that there was no reasonable expectation of profit.
Scenario 2
In this second scenario, the individual sells to an arm's length corporation ("Opco B") the other part of his business (the commercial department). Pharmaco and Opco B signs an agreement under which Pharmaco pays an amount to Opco B each year equal to a percentage of Opco B's sales in consideration for Opco B agreeing to continue to carry on the acquired business (the commercial department). For the purposes of this scenario, this amount is approximately $XXXXXXXXXX per year and would allow Opco B to earn income from the acquired business and Pharmaco to maintain its level of business.
You wish to know if, in this scenario, the amounts that Pharmaco pays to Opco B under the signed agreement would be deductible in computing its income from its business.
Scenario 3
In this third scenario, the individual sells the other part of his business (the commercial department) to a corporation that he incorporates ("Opco A"). Subsequently, Pharmaco and Opco A sign an agreement under which Pharmaco pays Opco A an amount each year equal to a percentage of Opco A's sales in consideration for Opco A agreeing to maintain the operation of the acquired business (the commercial department).
You wish to know if, in this scenario, the amounts Pharmaco pays to Opco A under the signed agreement is deductible in computing its income from its business.
Our Comments
As stated in paragraph 22 of Information Circular 70-6R5, Advance Income Tax Rulings, it is CRA's practice not to issue written opinions on proposed transactions otherwise than by way of advance income tax rulings. Furthermore, when it comes to determining whether a completed transaction has received appropriate tax treatment, the determination is made first by our Tax Services Offices as a result of their review of all facts and documents, which is usually performed as part of an audit engagement. However, we can offer the following general comments that we hope you will find useful.
As stated in Income Tax Technical News No. 25 dated October 30, 2002, the CRA's general position on the "reasonable expectation of profit" test is to apply it only in determining whether a taxpayer has a source of income within the meaning of the Act where the activity in question involves a personal or hobby element. Where there is no personal element to the business activity in question, as appears to be the case in the Particular Situation, this test will generally not be applied.
Furthermore, whether an expense incurred by a taxpayer is deductible in computing income from a business is a question of fact. The CRA generally does not make a determination on this issue without a full review and analysis of all the facts, legal documents and circumstances surrounding each particular situation. In particular, it is necessary to ensure that the expenditure was incurred by the taxpayer for the purpose of earning income from the business (paragraph 18(1)(a)), that it is not a capital expenditure (paragraph 18(1)(b)) and that it is reasonable in the circumstances (section 67). However, it appears from the jurisprudence that an expenditure made by a taxpayer to preserve the business or goodwill of its business is not a capital expenditure and therefore, subject to paragraph 18(1)(a) and section 67, may be deductible in computing the taxpayer's income from that business.
We hope that our comments will be of assistance.
Best regards,
Randy Hewlett
Manager
for the Director
Ontario Corporate Tax Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.