Governments use the tax system to give benefits and/or support to certain sectors of the economy. For example, Canadian farmers receive many unique tax benefits. Issues often arise, however, when an individual has more than farming in his or her mix of business activities. Consider, for example, an individual who was raised on a farm but ventures out, creating a successful career in law, all the while continuing to farm. Should this individual continue to benefit from the full suite of tax incentives for farmers or should he be restricted in his access to these benefits?
The Income Tax Act contains a provision that restricts an individual’s ability to claim farm losses if the taxpayer’s chief source of income is not farming or a combination of farming and something else. The amount of the farm loss that can be written off against other income of the taxpayer is reduced to an amount determined by formula. The deductible amount is the lesser of the actual farm loss and $2,500, plus the lesser of one-half of the loss in excess of $2,500 and $6,250, plus any deductions taken for scientific research and experimental development.
Three examples illustrate the application of this formula:
|Example 1||Example 2||Example 3|
|Actual farm loss||A||$2,500||$15,000||$50,000|
|1/2 of (A – 2,500)||B||Zero||$6,250||$23,750|
|Lesser of B and
|C plus $2,500
Any amounts that are non-deductible because of the application of the formula become restricted farm losses, which can be carried back three years or carried forward twenty years and deducted against farm income realized in any of those years.
This restriction on the deduction of losses will not apply where the farming activity, alone or in combination with other activity, is the taxpayer’s chief source of income. Until recently, a landmark Supreme Court decision (Moldowan v. the Queen) set out three criteria that were used to determine whether a taxpayer’s farming business was a chief source of income;
- measuring the time devoted to farming,
- the amount of capital committed to farming, and
- the actual or potential profit that could be derived from farming.
The Moldowan case, however, essentially went on to conclude that if farming income was subordinate to other types of income earned by the taxpayer, then the taxpayer’s chief source of income could not be said to be a combination of farming and some other source of income. As a result, unless the taxpayer earned only farming income, the farm loss rules would always apply, to restrict the deductibility of the losses from other sources of income.
Over the years, many tax professionals commented that the conclusions in Moldowan around the combination of farming and some other source of income seemed overly restrictive, and in fact some lower courts made decisions inconsistent with the precedents set by the Supreme Court in that earlier decision.
A recent Supreme Court of Canada case, The Queen v. Craig, reconsidered the prior decision in Moldowan and overruled that decision, bringing some additional clarity to the interpretation of the restricted farm loss rules. The Court found that farming could be a chief source of income by itself or in combination with another source of income. Farming need not be the only source of income in order for the taxpayer to claim the farm losses fully against other income.
The facts of the recent case are as follows:
- John Craig operated a successful law practice.
- He had investment income.
- He operated a race horse business (buying, selling and training horses for racing).
- The horse racing activities constituted a business — they were neither personal nor a hobby.
- Mr. Craig sought to deduct the full amount of farm losses realized in 2000 and 2001.
The Canada Revenue Agency reassessed Mr. Craig on the basis that his farm losses were limited to $8,750 in each of 2000 and 2001 because the horse racing business was a subordinate or sideline business and not his chief source of income. Mr. Craig appealed and won at the Tax Court of Canada. The Crown appealed to the Federal Court of Appeal and lost. The Crown subsequently appealed to the Supreme Court of Canada, which heard the appeal and decided in favour of the taxpayer. The Supreme Court noted that the provision in the Income Tax Act had two distinct elements; to avoid the restriction on farm losses, farming had to be the taxpayer’s chief source of income, or the taxpayer’s chief source of income had to be a combination of farming and something else.
This is good news for taxpayers who invest a significant amount of time, capital and energy into a farming business while at the same time continuing a separate career. The opportunity to report farm losses without limit will allow faster recovery of the tax shield available from farm losses.
E.O. & E.
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Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.