Eileen Reppenhagen, QuickBooks ProAdvisor
The Income Tax Act has an amendment and a new section that restricts taxpayers’ ability to claim losses from business or property against other income on a source by source basis. This just came into effect on January 1, 2005, even though it hasn’t been passed as law, but that’s nothing new.
The new proposed amendment to Section 3(d) and Proposed Addition of Section 3.1 is in my latest copy of my Stikeman 2004 - 36th Edition of the Income Tax Act. These amendments and additions have been nicknamed the ‘Trick – no Treat’ legislation because it was released in draft by the Department of Finance on October 31, 2003. The News Release is also available at http://www.fin.gc.ca/news03/03-055e.html
A new policy about Interest Deductibility and Related Issues, IT-533 was released in draft form the same day and it says that it does not take Section 3.1 into account.
Together these new laws and policies affect if and when taxpayers are allowed to claim losses from each business or property on a source by source basis. There is no provision to carry these losses back or forward if there is no expectation of a cumulative profit on a source by source basis. Property includes investment property as well as rental property and many other forms of property too numerous to mention here.
What exactly is Reasonable Expectation of Profit (referred to as REOP)? Haven’t there been court cases in the Supreme Court recently, for example in 2002 that overrode REOP?
“These legislative amendments and draft interpretation bulletin are aimed at clarifying how the income tax system links the deductibility of certain expenses and losses to a taxpayer’s prospects for profit, objectively determined.” Department of Finance News Release, October 31, 2003.
Will these laws and policies apply to common shares? Most of the time it will not according to the CRA, but it depends on whether or not there are dividends.
How should I be recommending my clients prepare for an audit if they claim losses on each individual business or property? What can I, as the accountant, do to minimize my risk?
Clients should keep a file for each business and each property with a history of the cumulative profit since acquisition. Every year that there is a loss, you will need to document your consideration of the cumulative profit and add it to the file. In the file there would be documentation proving that over the expected holding period for that business or property, the taxpayer will realize a cumulative profit from that business or property, excluding capital gains or losses.
The CRA will request a record of your thoughts at the time and it is impossible to create these records after the fact. You can only prepare them with the knowledge you have at the time you prepare the loss claim.
Watch for further legislative changes to this area as the application of this law is unclear about a number of points.
At this time, the losses are not allowed to be carried back or forward if there is no expectation of cumulative profit as determined each year. There is also no provision to capitalize any loss. The losses just fall off the table. Several tax lawyers I have heard speak recently seem to think that this situation will have to be amended.
Part of your regular ‘know your client’ procedures should be to set up a Quicken or QuickBooks file for every client with individual business or property assets set up in separate classes along with liabilities and a budget.
Now there is yet another reason besides an IVI Audit (see ProConnection Tax Tip Archive for November 2004) to track each business, investment or property separately as each is to be judged on its own merits.
There are three reasons for doing this:
CRA will require it during an audit;
It shows your clients that you not only care about their success by measuring and monitoring their plans, but that you care about which properties with losses may not be claimable;
It minimizes your risk and generates billable time which results in increases to your bottom line.
Ensuring the foregoing procedures will decrease the residual effect of an audit for REOP and interest deducibility.
Eileen Reppenhagen, QuickBooks ProAdvisor
Tel: 1 604 943.7414