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031, Farming Losses, Supreme Court of Canada, Tax Deduction

Canada v Craig, 2012 SCC 43

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SCC overrules its earlier decision regarding the test for subsection 31(1) limitation on loss deductions from farming activities. 

[PLEASE READ THE COMMENTS FOLLOWING THIS POST RE AMENDMENTS IN BUDGET 2013]

Canada v Craig, 2012 SCC 43

At issue was what factors one considers when determining whether farming and some other source of income constitutes a “chief source of income”, thereby avoiding the loss limitation in section 31 of the ITA.

The Court held that the approach it proposed to the application of Subsection 31(1) in Moldowan v. The Queen, 1977 CanLII 5 (SCC), was incorrect. The SCC revisited that decision and held that since subsection 31(1) provides two distinct exceptions to the loss deduction, the judge-made rule in Moldowan which had the effect of reading one exception out of the legislation could not stand.

The taxpayer’s primary source of income was intended to be, and in fact was, his professional income from law practice.  In addition to income from investments and gains from stock options, the taxpayer also bought, sold, trained, and maintained horses for racing.

The horse racing business had some profitable years, but also suffered some significant losses.  The Minister reassessed on the basis of Moldowan and limited the losses to that allowed by 31(1)(a). The taxpayer’s appeal was granted by the TCC, and this was upheld by the FCA, on the basis of Gunn v. Canada, 2006 FCA 281 (CanLII), 2006 FCA 281, on the finding that the combination of the horse-racing business and his law practice constituted the taxpayer’s chief source of income.

Section 31(1)(a) provides that, where a taxpayer’s chief source of income is neither farming nor a combination of farming and some other source of income, the taxpayer’s deductible farm loss is limited to $8,750 annually, the relevant portions of which read:

    31. (1) Where a taxpayer’s chief source of income for a taxation year is neither farming nor a combination of farming and some other source of income, . . . the taxpayer’s loss, if any, for the year from all farming businesses carried on by the taxpayer shall be deemed to be a total of

(a) the lesser of

(i)  the amount by which the total of the taxpayer’s losses for the year, determined without reference to this section and before making any deduction under section 37 or 37.1, from all farming businesses carried on by the taxpayer exceeds the total of the taxpayer’s incomes for the year, so determined from all such businesses, and

(ii)  $2,500 plus the lesser of

(A)  1/2 of the amount by which the amount determined under subparagraph 31(1)(a)(i) exceeds $2,500, and

(B)  $6,250, and

The provision allows for two exceptions to its loss deduction limitation. The first is where farming is the taxpayer’s chief source of income. The second is where the taxpayer’s chief source of income is a combination of farming and some other source of income.

The court said that one must take a contextual approach and cannot resign to simply adding up two sources of income. One must consider the  capital invested in the farming business and in the second source of income; the relative amounts of income from each of the two sources of income; the time spent on each of the two sources of income; and the taxpayer’s ordinary mode of living, farming history, and future intentions and expectations (including actual and potential profitability) when dealing with subsection 31(1).  If the foregoing factors have the tendency to show that the taxpayer places significant emphasis on both the farming and the non-farming sources of income, there is no reason to hold that a combination of the two should not constitute a chief source of income, and meeting the requirements of one of the exemptions to 31(1).

The Court stated at paragraph 41 that “as long as the taxpayer devotes considerable time and resources to the farming business, the fact that another source of income produces greater income than the farm does not mean that such a combination is not a chief source of income for the taxpayer.”

The court noted that although both endeavours must be significant ones for the taxpayer, they need not be connected and farming need not be the primary source of income. The Court stated at paragraph 39:

I see nothing in the words or context in s. 31(1) to support the proposition that farming must be the predominant source of income when viewed in combination with another source, in order to avoid the loss deduction limitation of the section. It is also not possible to relegate s. 31(1) to applying only to “hobby” or “gentleman” farmers because, for a loss to be deductable at all, farming must be a source of income. A taxpayer who is engaged in farming in a non-commercial manner, with no profit or intention to profit, does not have a source of income from farming and therefore no loss for income tax purposes, limited or not (Stewart v. Canada, 2002 SCC 46 (CanLII), 2002 SCC 46, [2002] 2 S.C.R. 645, at paras. 51-54).

When considering the factors, not every one of them need be significant.  In making the factual determination needed, the court considering a taxpayer’s activities must consider all the factors together, and determine whether the taxpayer places significant emphasis on each of the farming business and other earning activity. If the taxpayer does so, the combination will constitute a chief source of income and avoid the loss deduction limitation in 31(1).

This interpretation is consistent with the ITA’s general policy that unless there are specific exceptions, a taxpayer may offset losses from one business or source of income against profits from another without limitation.

In this case, the taxpayer’s activities constituted a business (not a hobby), and the taxpayer devoted a significant amount of capital and a very significant part of his daily work routine to the farming business and was an active member of and contributor to the community of standard‑bred racing.

The new two-step test for subsection 31(1) is:

  1. Is there a farming business such that it forms a source of income from which losses may be deducted as oppose to a hobby or personal endeavour?  Look to the test in Stewart v. Canada, 2002 SCC 46: Is the farming operation being run in a “commercial manner” such that there is no personal or hobby element to the operations, or (if there is a personal or hobby element) undertaken in a sufficiently commercial manner in accordance with objective standards of business-like behaviour.  If so, it is a business.
  2. Is the taxpayer limited in claiming the losses of the farming business against another source of income? The limitation applies unless (a) the farming operation is the chief source of income for the taxpayer, or (b) the farming operation and another source of income is the chief source of income for the taxpayer.  In considering (b) one must consider the following factors together: (i) the amount of capital invested in farming and the other source of income; (ii) the income from each of the two sources of income; (iii) the time spent on the two sources of income; and (iv) the taxpayer’s ordinary mode of living, farming history and future intentions and expectations.

COMMENT

From Budget 2013 (Economic Action Plan 2013) Annex 2

Restricted Farm Losses

The restricted farm loss (RFL) rules apply to taxpayers who have incurred a loss from farming, unless their chief source of income for a taxation year is farming or a combination of farming and some other source of income. The RFL rules limit the deduction of farm losses to a maximum of $8,750 annually ($2,500 plus ½ of the next $12,500). Farm losses incurred in a year in excess of that limit can be carried forward for 20 years to be claimed against farming income.

The RFL rules were introduced in 1951. In 1977, the Supreme Court of Canada in Moldowan v. The Queen, [1978] 1 SCR 480, interpreted the chief source of income test in the RFL rules. The Court held that farming that results in a loss could satisfy the chief source of income test (and the RFL rules would therefore not apply) if farming is the taxpayer’s chief source of income in combination with a non-farming source of income that is a subordinate source or a side-line employment or business. The Moldowan decision is consistent with the purpose of the chief source of income test, which is to ensure that taxpayers for whom farming is not the principal occupation are limited in their ability to deduct farm losses from their nonfarm income.

In 2012, in The Queen v. Craig, 2012 SCC 43, the Supreme Court overruled Moldowan by holding that the particular taxpayer could meet the chief source of income test even though his primary source of income was practicing law, and farming (i.e., horse racing) was a subordinate source of income. In effect, the Court established a test that permits the full deduction of farming losses where a taxpayer places significant emphasis on both farming and non-farming sources of income, even if farming is subordinate to the other source of income.

To restore the intended policy of the RFL rules, Budget 2013 proposes to amend them to codify the chief source of income test as interpreted in Moldowan. This amendment will clarify that a taxpayer’s other sources of income must be subordinate to farming in order for farming losses to be fully deductible against income from those other sources.

Recognizing that the deductible limit under the RFL rules has not been increased since 1988, Budget 2013 also proposes to increase the RFL limit to $17,500 of deductible farm losses annually ($2,500 plus ½ of the next $30,000).

These measures will apply to taxation years that end on or after Budget Day.

– Sas Ansari, BSc BEd PC JD LLM PhD (exp) CPA In-Depth Tax 1, 2 &3

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031, Farming Losses, Income Tax Act, Tax Court of Canada, Tax Deduction

Curtis v The Queen, 2012 TCC 248

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What a Farmer Needs to do, at a Minimum, so as Not to Get Caught by Section 30’s Limitation on Farming Losses.

Curtis v The Queen, 2012 TCC 248

The issue here was whether the taxpayer’s farm losses were limited by the rules in section 31, thus whether farming or a combination of farming and some other source of income constitutes a chief source of income for the taxpayer in the tax year.

The Court concluded that in order to constitute a “Chief source” of income, the farming operations must at least have the potential to be profitable based on the expectations and operations of the taxpayer.

FACTS

Mr. Curtis (“taxpayer”) had a life-long interest in farming. After a career as a motor vehicle mechanic, and while employed at Air Canada, he bought a 230-acre farm (of which 150 acres were arable – though the farm had been out of production for a number of years).

The taxpayer and his family lived on the farm, which was about 100 km from his place of employment. The Crown did not argue that the taxpayer did not have a business, nor were any of the expenses or their amounts challenged. The Court, it seemed, considered both these to be in question.

Without a formal business plan, but based on a life-long dream, the taxpayer wished to operate a 40 cow cow-calf operation that would earn him between$22,500-24,400 in revenues annually.  The operations never reached ideal levels and, in part due to some accidents and market setbacks, the operations had losses which were for the 2005,2006, and 2007 tax years $15,500, $28,000, and $104,000 respectively. He stopped the business in 2010 as the tax assessment precluded him from continuing, and has now put the property up for sale.

The taxpayer also had an income from some crops, $18,000 from wind-turbine operations (by a third party), and his employment income from Air Canada (where he worked 4 days on and 4 days off earning between $75,00-100,000).

The taxpayer provided only a vague estimate of the time he spent working on the farm in a CRA questionnaire, but for trail estimated that he spent 14 hours each day 7 days a week working on the farm.

The taxpayer spent about $75,000 on farming equipment and had expenses for farm use of his pick-up truck, interest, insurance, property taxes, and hydro.

ANALYSIS

The court did not think the taxpayer’s time estimates were accurate and stated that the issue was not being decided on the basis of hours worked on the farm operations, though the court concluded that the time spent on farming was significantly less than spent on his employment with Air Canada. The court noted that the fixed costs alone exceeded the farming revenue in all but three taxation years.

The relevant portions of Subsection 31(1) of the ITA reads:

31. (1) Where a taxpayer’s chief source of income for a taxation year is neither farming nor a combination of farming and some other source of income, […] [emphasis added]

The court began the analysis with the Supreme Court of Canada (SCC) decision in Moldowan v The Queen, [1978] 1 SCR 480 (as the leading decision on restricted farm losses), and stated that on the meaning of “chief source” of income the SCC wrote:

Whether a source of income is a taxpayer’s “chief source” of income is both a relative and objective test. It is decidedly not a pure quantum measurement. A man who has farmed all of his life does not cease to have his chief source of income from farming because he unexpectedly wins a lottery. The distinguishing features of “chief source” are the taxpayer’s reasonable expectation of income from his various revenue sources and his ordinary mode and habit of work. These may be tested by considering, inter alia in relation to a source of income, the time spent, the capital committed, the profitability both actual and potential. A change in the taxpayer’s mode and habit of work or reasonable expectations may signify a change in the chief source, but that is a question of fact in the circumstances. [emphasis added]

Based on this, the Court concluded that the taxpayer’s chief source of income was not farming, but the question remained whether farming and Air Canada employment were his chief source of income.  The Court again referred to the SCC decision above, and quoted:

The reference in s. 13(1) to a taxpayer whose source of income is a combination of farming and some other source of income is a reference to class (1). It contemplates a man whose major preoccupation is farming. But it recognizes that such a man may have other pecuniary interests as well, such as income from investments, or income from a sideline employment or business. The section provides that these subsidiary interests will not place the taxpayer in class (2) and thereby limit the deductibility of any loss which may be suffered to $5,000. While a quantum measurement of farming income is relevant, it is not alone decisive. The test is again both relative and objective, and one may employ the criteria indicative of “chief source” to distinguish whether or not the interest is auxiliary. A man who has farmed all of his life does not become disentitled to class (1) classification simply because he comes into an inheritance. On the other hand, a man who changes occupational direction and commits his energies and capital to farming as a main expectation of income is not disentitled to deduct the full impact of start‑up costs. [emphasis original to Curtis]

Thus, the combination approach applies to a person whose major pre-occupation is farming, but carried on other businesses on the side.  The Court noted that there is some uncertainty with the SCC decision, and referred to the decisions of the Federal Court of Appeal in Gunn v. Canada, 2006 FCA 281, and Canada v Craig, 2011 FCA 22 (which have been granted leave to appeal by the SCC).

In Gunn, the FCA interpreted the combination question to require a look only at the cumulative effect of the aggregate of the capital invested in each of the sources of income, the aggregate of the incomes from the various sources, and the aggregate of the time spent on each of the sources. This was to be done in light of the “ordinary mode of living, farming history, and future intentions and expectations”.  In Craig, the FCA stated that based on Gunn, the “farming source must make a meaningful contribution to the aggregation formula so as to suggest that farming is or has the potential to be a chief source.”

The court stated that regardless of the outcome of the issue of whether farming must be a predominant source of income, when looked at in combination, or not, the taxpayer’s appeal fails.  If it must be the predominant source of income, the taxpayer’s farming income won’t meet this test. If being predominant is not a requirement, then based on the “reasonable expectation of income, ordinary mode and habit of work, time spent, capital committed, actual and potential profitability, ordinary mode of living, farming history, and future intentions and expectations” of the taxpayer, then farming is not a chief source by itself or in combination.

The court noted that profitability if a significant consideration when looking at the question of chief source of income, and though the taxpayer invested significant capital in the farming operations and revolved his mode of living around the farming operations, and all other things aside the taxpayer failed to meet the “chief source” test based on his intentions and expectation, actual income derived from activities, and profitability (actual and potential) (para 35).  The Court quoted from the FCA decision in Gunn:

[…] if it is unlikely that the taxpayer’s farming operations will ever be profitable, notwithstanding all the time and capital the taxpayer is willing and able to devote to farming, the conclusion must be that farming is not a chief source of the taxpayer’s income.

Thus, based on the testimony of the taxpayer and the self-imposed limitations on the operations, the business was economically unattainable and could not be profitable.  The Court quoted from the FCA decision in Craig:

I am suggesting then that the test is whether the taxpayer’s mode of operation has sufficient commitment and commerciality and profit potential to be recognized as a chief source applying the Moldowan commitment and profitability criteria. Looking at time spent, capital invested, and a meaningful profit potential arising from a dedication to profitability, the question of whether the taxpayer is recognizable as a committed, viable commercial player in a genuine economic sector of the economy should be readily answered. Such a test will not put recreational farmers in an advantaged position. [emphasis added]

Justice Boyle emphasised that one significant and predominant consideration in this case was the absence of even the potential of profitability.

– Sas Ansari, BSc BEd PC JD LLM PhD (exp) CPA In-Depth Tax 1, 2 &3

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