Nov 01, 2024
Introduction: The Nature of Business Income for Tax Purposes
A Canadian tax resident is taxable on income from all sources, including from business and property. A taxpayer’s income from a business or property for a particular taxation year is defined by subsection 9(1) of the Income Tax Act as “the taxpayer’s profit from that business or property for the year.”
The term “profit” is not defined by the Income Tax Act, however. Generally speaking, “profit” is accepted to refer to net profit, or the amount of revenue remaining after the deduction of expenses incurred for the purpose of earning the revenue.
But the question of how, and when, profits are recognized for tax purposes is driven heavily by the application of “well-accepted accounting principles” in tax law. Depending on the taxpayer’s activities, the question of when profits are realized can have a major impact on tax owing year-by-year.
This article aims to explore how the common law, statutory rules of the Income Tax Act, and “well-accepted accounting principles” may bear on determining an individual’s profit from a business or property in a particular taxation year.
First, this article begins by exploring the primary statutory rules that bear on a taxpayer’s “profit” for a taxation year, including sections 9 and 18 of the Income Tax Act. Second, this article explores the role that “well-accepted accounting principles” play in the determination of profit. Third, this article presents some pro tax tips and frequently asked questions concerning the realization of income and deductibility of expenses.
The Statutory Regime for Profit from a Business or Property under the Income Tax Act
As mentioned above, subsection 9(1) of the Income Tax Act states that a taxpayer’s income from a business or property is that taxpayer’s “profit.” The term “profit” is inherently a net concept, and a taxpayer’s profit under subsection 9(1) has been found by Canadian courts to mean the difference between a taxpayer’s revenues and any expenses incurred to earn that income, with consideration to well-established business principles.
Section 18 of the Income Tax Act imposes statutory restrictions on the types of expenses that are deductible for calculating profit from a business or property. To be more precise, paragraph 18(1)(a) states that, in computing a taxpayer’s income from a business or property, “no deduction shall be made in respect of an outlay or expense except to the extent that it was made or incurred… for the purpose of gaining or producing income from the business or property.” This provision re-affirms explicitly that there is no deduction for an expense not incurred to earn income.
Section 18 includes a number of other restrictions on expenses, specifically and broadly, for various policy reasons. For example, paragraph 18(1)(h) further restricts taxpayers from claiming a deduction for an expense incurred for “personal or living expenses” (other than a limited range of travel expenses incurred by a taxpayer while carrying on a business).
While the concept of “profit” under subsection 9(1) intuitively limits the deductibility of expenses to those incurred to earn income, paragraphs 18(1)(a) and 18(1)(h) further refine the concept that an expense must have a genuine and defined business purpose in order to be deductible for tax purposes.
What are “Well Accepted Accounting Principles”?
Note that sections 9 and 18 of the Income Tax Act only tell part of the story. This is because the question of when a taxpayer realizes profit—the timing of income—is not always addressed by the Income Tax Act itself.
For tax law purposes, “well-accepted accounting principles” are similar, but not synonymous, with GAAP, such as those described in the CPA Canada CPA Handbook, set out by the Canadian Accounting Standards Board (“AcSB”), or those forming part of International Financial Reporting Standards (“IFRS”).
It should be clarified that well-accepted accounting principles are only interpretive aids, and to the extent they influence the calculation of income, they can only do so on a case-by-case basis. As stated by the Supreme Court of Canada in Canderel Ltd. v. Canada, [1998] S.C.J. No. 13, for example:
The better view is that GAAP will generally form the very foundation of the “well-accepted business principles” applicable in computing profit … While GAAP may more often than not parallel the well-accepted business principles recognized by the law, there may be occasions on which they will differ, and on such occasions the latter must prevail.
But, well-accepted accounting principles still play a key role in providing an accurate picture of a taxpayer’s income for a given year. And generally speaking, the Income Tax Act rarely overrides the application of GAAP and well-accepted accounting principles. (The Income Tax Act generally only does so where accounting principles would result in an unexpected distortion in a taxpayer’s tax base, such as prohibiting deduction on assets in favour of permitting claims for capital cost allowance (“CCA”) at prescribed rates under paragraphs 18(1)(b) and 20(1)(a) respectively, and by prohibiting the use of the last-in, first-out (“LIFO”) method for evaluating inventory for tax purposes.)
If well-accepted accounting principles support a particular position for reporting and recognizing income, and the case law and Income Tax Act do not challenge or override that reporting position, then that reporting position is permissible for income tax purposes.
When Might Well Accepted Accounting Principles be Relevant for Tax Purposes?
As mentioned above, the Income Tax Act does not typically override the application of GAAP, and it does codify many general accounting principles (with a few notable exceptions). But we can explore a few examples to illustrate the importance that well-accepted accounting principles might still play in determining a taxpayer’s income and profits from a business.
First, we can consider a taxpayer who provides services for consideration. That taxpayer periodically bills clients for those services, and becomes legally entitled to payment at that time. Under IFRS, and under most accounting standards, income (and profit) would be recognized when an amount becomes receivable (i.e. on an accrual basis), as opposed to on a cash basis. This is consistent with the provisions of the Income Tax Act and Canadian case law. On this basis, for income tax purposes, profit would be taxed as amounts become receivable, less expenses incurred to earn that income.
In contrast, we can consider a taxpayer who manufactures commodities for resale. That taxpayer incurs manufacturing costs to produce inventory for resale. Unlike the taxpayer who renders services, the taxpayer who manufactures commodities only realizes income when the final inventory is sold. Under IFRS, and under most accounting standards, the cost of manufacturing inventory would be added to the taxpayer’s cost of goods. When the taxpayer sells inventory, the taxpayer’s profit will be the sale price for inventory, minus the cost of goods (and other expenses incurred to sell that inventory, or to operate the taxpayer’s business). This is consistent with IFRS, and most accounting standards, for inventory-based business models. Further, section 10 of the Income Tax Act codifies this principle by requiring that the cost of creating inventory be added to the cost of goods for tax purposes.
But what if we consider a taxpayer who renders services, and receives consideration-in-kind (i.e. property) as payment? That taxpayer may then sell that property as another part of his or her business to arm’s length purchasers. One topical example is a taxpayer who engages in cryptocurrency staking. A taxpayer who stakes cryptocurrency might contribute to the stability of a blockchain network by doing so, and will receive a consistent stream of cryptocurrency tokens as a reward. That taxpayer may then turn around and sell those tokens for additional income. That taxpayer might be staking only to acquire cryptocurrency for trading, for example, as part of a larger cryptocurrency-trading business.
A taxpayer may be incentivized to adopt an inventory-based accounting policy for income and expenses, as opposed to a services model, for example. This is because the receipt of cryptocurrency staking rewards under a services model would constitute profit for accounting purposes, and, by extension, possibly for tax purposes. The taxpayer will owe income tax on the receipt of cryptocurrency tokens, and will be required to sell those tokens, recognizing additional income (or a loss) on resale to pay for those initial taxes.
In contrast, under an inventory-based business model, the receipt of cryptocurrency tokens from staking would simply add to the taxpayer’s inventory, and the cost of acquiring those staked tokens would be added to the cost base of that taxpayer’s inventory. The only taxable event would occur on disposition of those tokens, allowing the taxpayer to better control when profit is realized. However, an inventory-based model may not be principled, because the taxpayer is, by staking cryptocurrency tokens, fundamentally rendering a service.
Neither the services nor the inventory-based business model clearly offend the rules of the Income Tax Act. However, well-accepted accounting principles, including IFRS, have been undergoing significant developments over the last decade, in an effort to develop a consistent and coherent model for accounting for cryptocurrency-based businesses. As the Supreme Court of Canada in Canderal Ltd., explained, a taxpayer should adopt the method of accounting that best depicts the taxpayer’s financial situation, and taxpayers are generally free to adopt a method of accounting that is not inconsistent with (a) the provisions of the Income Tax Act, (b) well-established case law principles or rules of law, and (c) what Canadian courts have frequently referred to as “well-accepted accounting principles.”
So, if the applicable accounting methodology is sound and principled, it is open to a taxpayer to use that methodology. In doing so, should the CRA disagree, it bears the onus of demonstrating that an alternative methodology better depicts the financial reality of the taxpayer.
Pro Tax Tip: Profit Recognition is a Legal Concept, not an Accounting Concept. Engage a Professional Canadian Tax Lawyer to Confirm
It is worth emphasizing that, while well-accepted accounting principles drive the calculation of profit from a business or property for tax purposes, the calculation of profit for tax purposes is still a legal question. Any filing position taken by a taxpayer is subject to challenge by the CRA as a result.
Crucially, in cases where a taxpayer has provided an accurate picture of income for the year, consistent with the Income Tax Act, case law, and well-accepted accounting principles, the onus is placed on the Minister to demonstrate that the figures present do not reflect an accurate picture of the taxpayer’s income, or that another method of computation would produce a more accurate picture.
So, if your business model is unconventional, it is worth obtaining the opinion of a professional Canadian tax lawyer to help guard against potential litigation. When deciding how to recognize profit for tax purposes for your business, an expert Canadian tax lawyer can prepare a privileged and confidential memorandum examining how profit from a business or property could be reported, and which is the most appropriate method.
While an accountant or a CPA, or even the CRA itself, can comment on correct accounting policies and practices, it is ultimately tax lawyers and court rulings that answer this question. That memorandum can set out the roadmap to defending your filing position, if the CRA were to ever disagree with your reporting method. As well, the existence of the memorandum will prove our diligence and serve to counter the CRA’s attempts to justify imposing gross negligence penalties.
FAQs
1) What are “well-accepted accounting principles” for Canadian tax purposes?
For tax law purposes, “well-accepted accounting principles” are similar, but not synonymous, with GAAP, such as those described in the CPA Canada CPA Handbook, set out by the Canadian Accounting Standards Board (“AcSB”), or those forming part of International Financial Reporting Standards (“IFRS”). If well-accepted accounting principles support a particular position for reporting and recognizing income, and the case law and Income Tax Act do not challenge or override that reporting position, then that reporting position may be permissible for income tax purposes.
2) My accountant has advised me that I can use several different accounting principles for recognizing income. Which should I use?
If well-accepted accounting principles support a particular position for reporting and recognizing income, and the case law and Income Tax Act do not challenge or override that reporting position, then that reporting position is permissible for income tax purposes.
However, the calculation of profit for tax purposes is still a legal question. Any filing position taken by a taxpayer is subject to challenge by the CRA. If your business model is unconventional, or if you are uncertain about how to recognize income for tax purposes, you should consult with an expert Canadian tax lawyer to confirm the best option or options available to you.
Disclaimer: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the articles. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
