Introduction To Canada Tax System ' Reasonability Of Business Expenses

• Published date: 09 December 2022
• Subject Matter: Tax, Income Tax
• Law Firm: McCarthy Tétrault LLP
• Author: Mr Spotlight Can-Asia, Joyce Lee, Chia-yi Chua, Gong Ming Zheng and Jesse Waslowski

For Canadian income tax purposes, all deductions for expenses must be "reasonable in the circumstances" under section 67 of the Income Tax Act (Canada). The recent decision from the Federal Court of Appeal (the "FCA") Peach v. Canada, 2022 FCA 163 illuminates what it means for an expense not to be reasonable, and rejects questioning a taxpayer's business judgment in this exercise. Mr. Peach (the taxpayer in the decision) owned several rental properties that were rented to his three sons, and he sold life insurance and mutual funds to a client base largely consisting of friends and family. Mr. Peach claimed business losses during his 2011 taxation year for the operation of the properties and the financial services business. During the 2011 year, Mr. Peach transferred one of the rental properties to one of his sons but did not report either this disposition nor any associated capital gain or loss in his income tax return. Moreover, also during the 2011 taxation year, the taxpayer earned only $27 in revenue from his life insurance business, but claimed over $19,600 of business expenses for said business.¹

In issuing the reassessment of Mr. Peach's income, the Minister of National Revenue removed all rental revenue and losses associated with his rental properties, reduced the amount of business expenses he claimed for his business, and included a capital gain on the transfer of the rental property to his son. The taxpayer appealed the reassessment to the Tax Court of Canada (the "Tax Court"),² and the Tax Court reduced Mr. Peach's capital gain on the transfer of the rental property, but otherwise upheld the Minister's assessment. The taxpayer appealed to the FCA.

A notable factor in the decision was that Mr. Peach's rental activity involved significant personal components and Mr. Peach was not pursuing a profit, so the rentals did not constitute a source of income as described in Stewart v. Canada, 2002 SCC 46 ("Stewart"). As stated by the FCA, "all three of the appellant's tenants had been his sons, and ... the appellant had set the properties' rental rates below market value".³ We invite you to read our earlier post for further details on Stewart and the source concept of income in Canadian income tax.

The Tax Court and the FCA also made interesting comments respecting what constitutes a reasonable expense. The courts could not have been more clear that, as suggested by the taxpayer, "the Tax Court's role is not to evaluate a taxpayer's business acumen".⁴...