What does ‘Reasonableness’ Mean in Canadian Tax Law?
When Canadians think of taxes, they likely think of strict rules that come out of the Income Tax Act. Parts of the Act, however, do not really work that way, and rather turn on less clearly defined concepts, such as “reasonableness” or what is “reasonable” in the circumstances. Many protracted disputes between taxpayers and the Canada Revenue Agency, as well as much of what Tax Lawyers do, involves laws that depend on “reasonable” amounts.
What is Reasonable or Reasonableness?
The Canada Revenue Agency often uses reasonableness tests to signal that they would prefer to delegate decisions to what is reasonable, rather than devise their own strict rules and regulations. Reasonableness language is often used where a given practice is very context dependant, and bright lines in the sand would be unhelpful. When a law is framed in terms of reasonableness, in effect, it allows the courts to define “tests”, the factors that will help determine whether a given case is reasonable or not. This extends all across Canadian law, from lawyers’ bills to employment disputes to family law.
So where does “reasonable” pop up in the Income Tax Act? One of the most important places is with business deductions, as the Canada Revenue Agency can deny or limit deductions from business income they consider unreasonable, including excessive spending on advertising or flashy meals. In the newly proposed changes to the tax code, in an effort to avoid “income splitting”, Parliament has proposed placing an explicit “reasonableness” test on dividends paid to the family members of business owners. This change hopes to prevent owners limiting their tax bill by compensating their children or spouses in amounts unreasonably exceeding the contribution they make to the business.
As a general rule, all deductions taken by taxpayers must be reasonable under the circumstances.
What is a Reasonable Expectation of Profit?
Distinguishing businesses from hobbies, and thus whether income is taxable and losses deductible, considers whether the activity was undertaken with a Reasonable Expectation of Profit. Alongside other considerations, the Courts consider whether your activities could reasonably be expected to make money on the basis of your training, profit and loss over past years, and your plans may determine whether or not you need to pay taxes if you make money from a given activity. This forms part of the basis for hobby gambling winnings being non-taxable.
For example, if you are law firm marketing agency, a law firm marketing company, a search engine agency, or an e-commerce store that sells the best sweatpants, and you turn a profit the courts could ask if you are reasonably expected to make money on the basis of your training.
If you lose money in a business venture, you can deduct it against your other income in a year. In a recent case, a man in Thornhill, Ontario started two ventures he claimed to be businesses, one as a “real estate consultant”, and one as a personal trainer. He was, frankly, not particularly good at either of them; he took a bath on both ventures, and they soon folded. In his real estate “business”, he would essentially ask people if they could use advise on real estate transactions, even though he lacked any formal training. As a personal trainer, he would invite clients into his condominium’s recreational area to work out and critique them. He then tried to deduct the money he lost in these schemes from his income to reduce his tax bill. It may have been tough for Mr. X to read the judgement, as the court is extremely critical of his capacity as a businessman. As he was untrained, did not seek to minimize his risks, and the Court generally thought his plan was bad, they did not consider him to have been running businesses, and so also not to have been generating business losses. This is a good example of a reasonableness test in action; a person of good judgment would likely agree that he could not reasonably have expected to profit off of these activities, but the court did not apply rigid rules in coming to its conclusion. Multi-level marketing schemes have often been deemed not to be businesses on a similar basis.
Employees and What is Reasonable
While many of the “reasonableness” provisions relate to business income, some also apply to employees. Generally, employees of other business cannot deduct expenses incurred in earning their income. However, there are some exceptions, including reasonable expenses for an office or assistant if required by the employee’s contract. In Morgan v The Queen, a taxpayer ended up in hot water because as an employee he used a tactic more frequently employed by businesses: he hired his wife as an assistant. He paid her quite well ($35,000 and $52,500), and the Canada Revenue Agency argued that this was not reasonable, and that on the basis of the services received, a more reasonable deduction would have been about $25,000. The Court dismissed their case for other reasons, but in the end said that he would have considered these deductions to be excessive. The Judge considered that the most a reasonable business person would have paid would have averaged about $25,000 per year, which he arrived at by comparing wages on Workopolis.com with the amount she worked over the year.
Reasonableness and the Income Tax Act
The above are only a few examples- as of writing, “reasonable” and “reasonably” show up 1219 times in the Income Tax Act, without looking at any tax regulations, provincial acts, or other kinds of taxes. R&A Tax Law also deals with gross negligence penalties imposed by the CRA when it considers taxpayers to have made unreasonable errors.
On the one hand, these kinds of provisions allow for a flexible legal system, and provides judges (or auditors), with all of the information in front of them, the ability to make context-sensitive decisions. On the flip side, however, “reasonableness” provisions decrease certainty. When a given factor only plays a limited role in a broader determination of reasonableness, it can often be hard to know where you stand. For example, a taxpayer required to limit deductions to those that are “reasonable” may need to choose between claiming expenses cautiously in an attempt to avoid being audited and claiming them boldly to avoid leaving money on the table. Once something gets to Court, reasonableness may help make decisions that accord with common sense, but it is less helpful at letting you know what to do during tax season. This uncertainty means that reasonableness rules can result in complicated legal disputes, and that policymakers should be conscious of this inherent trade-off between flexibility and certainty.
Lawyers, and particularly lawyers whose practice involves litigation, are used to dealing with reasonableness, and whether the CRA is questioning the reasonableness of part of your return or you are wondering if you can reasonable make a given claim, a tax lawyer may be the right person to call. R&A Tax Law has the experience and skill necessary to resolve your dispute about reasonableness or what is reasonable in the circumstances. Don’t wait, call us today!
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions you should consult a lawyer.