Overview – When Can the CRA Deny a Business Expense?

Many Canadian business owners assume that if a business expense was actually incurred and was genuinely connected to earning business income, it will be fully deductible for income tax purposes. That assumption is not always correct. Even where an expense satisfies the general deductibility requirements under the Income Tax Act, the Canada Revenue Agency (CRA) may still reduce or deny part of the deduction if the amount claimed is considered unreasonable in the circumstances.

Section 67 of the Income Tax Act is one of the CRA’s most important tax audit tools for challenging excessive business expenses. Unlike many other deduction provisions, section 67 does not determine whether a particular type of expense is deductible. Instead, it asks a different question: assuming the expense is otherwise deductible, was the amount claimed reasonable in the circumstances? If the answer is no, the CRA may reduce the deduction or, in appropriate cases, deny it altogether.

The provision applies across a broad range of business expenditures and frequently arises during CRA tax audits and tax reassessments involving owner-managed corporations, closely held businesses, and related-party transactions. Common areas of dispute include management fees, salaries paid to family members, shareholder compensation, professional fees, travel and entertainment expenses, interest payments, and other discretionary business expenditures that the CRA believes exceed what a reasonable business person would have paid.

Section 67 does not give the CRA unlimited authority to second-guess legitimate business decisions. Canadian courts have consistently recognized that businesses are free to negotiate commercial arrangements that may ultimately prove successful or unsuccessful. The issue is not whether the CRA would have made the same business decision, but whether the amount paid can be objectively justified, having regard to all of the surrounding circumstances.

This article explains how section 67 of the Income Tax Act operates, how Canadian courts determine whether an expense is “reasonable in the circumstances,” the factors commonly considered during CRA audits and tax litigation, and the practical steps that business owners, accountants, and tax advisors can take to reduce the risk of a reassessment.

Because the outcome of a section 67 dispute often depends on the quality of the supporting evidence, the commercial rationale for the expenditure, and the surrounding facts, obtaining advice from an experienced Canadian tax lawyer before or during a tax audit can significantly improve a taxpayer’s ability to defend legitimate business expense deductions.

What Does “Reasonable in the Circumstances” Actually Mean?

Section 67 of the Income Tax Act is often misunderstood because it does not determine whether a business expense is deductible in the first place. Instead, it applies only after a taxpayer has established that the expense is otherwise deductible under another provision of the Act. The provision imposes a separate limitation, providing that an otherwise deductible outlay or expense may be deducted only to the extent it is reasonable in the circumstances.

In practical terms, section 67 focuses on the amount of the expense rather than its character. The issue is not whether the taxpayer incurred a legitimate business expense, but whether the amount claimed is commercially reasonable. This distinction is important because many taxpayers mistakenly believe that proving an expense was incurred for business purposes automatically entitles them to deduct the full amount. Section 67 says otherwise.

Canadian courts have consistently described section 67 as a quantitative limitation rather than a qualitative one. The provision does not ask whether the taxpayer made a good business decision or whether the expense ultimately generated profits. Instead, it asks whether the amount paid was reasonable, having regard to all of the surrounding circumstances. Even where an expense satisfies the income-earning purpose test under paragraph 18(1)(a) of the Income Tax Act or forms part of the computation of business income under section 9, the deduction may still be reduced if the amount itself is excessive.

The leading authority remains Gabco Ltd. v. Minister of National Revenue, where the court explained that the issue is not whether the CRA or the courts would have negotiated the same amount. Rather, the question is whether no reasonable business person would have agreed to pay that amount, having only the taxpayer’s business interests in mind. This objective commercial standard continues to guide the application of section 67 and has been reaffirmed in subsequent jurisprudence.

In Gabco, the issue concerned the remuneration paid to the president’s brother, whom the family-owned construction company employed. The court found the compensation reasonable, given the services rendered and the overall benefit to the company. In essence, the appropriate remuneration reflected the fair market value of the services, representing the amount a typical employer would pay in an open market, regardless of family relationships.

Equally important is what section 67 does not do. It is not a licence for the CRA to second-guess ordinary commercial decisions or to reassess a taxpayer simply because, with the benefit of hindsight, a different business decision might have been made. Businesses routinely enter into transactions that involve risk, uncertainty, or imperfect information. Canadian courts have repeatedly recognized that poor business judgment alone does not make an expense unreasonable. The focus remains on whether the amount paid can be objectively justified based on the facts that existed when the expense was incurred.

This distinction has significant practical implications during a CRA tax audit. A taxpayer defending a business expense should not focus exclusively on proving that the expense was incurred. The stronger approach is to demonstrate why the amount paid was commercially reasonable by reference to the services received, market conditions, comparable transactions, the risks assumed, the anticipated business benefit, and the overall commercial context in which the decision was made. Those factors often determine whether a deduction survives a CRA tax reassessment.

How Does the CRA Decide Whether an Expense Is Unreasonable?

Whether an expense is “reasonable in the circumstances” is ultimately a question of fact. There is no statutory formula, fixed percentage, or bright-line test that determines whether a business expense will satisfy section 67 of the Income Tax Act. Instead, the CRA and the courts examine the surrounding commercial circumstances to determine whether the amount claimed can be objectively justified.

The courts have repeatedly emphasized that the analysis must focus on the amount of the expenditure rather than the wisdom of the underlying business decision. Although the determination involves an element of judgment, there must always be an objective basis for concluding that the amount paid was commercially reasonable. In Massicolli c. R., 2012 CarswellNat 5796, the Tax Court explained that the reasonableness analysis measures the magnitude or quantum of the expense and requires an objective component. The question is not whether a less expensive alternative was available, but whether the amount paid was one that a reasonable business person could have agreed to under comparable circumstances.

Several factors commonly influence that analysis. One of the most important is the value of the goods or services received in exchange for the payment. Where the expenditure relates to compensation, management fees, consulting services, professional fees, or cryptocurrency business expenses, the CRA will often consider whether the amount reasonably reflects the value of what the business actually received. This analysis can be especially important for cryptocurrency mining operations and digital-asset businesses, where taxpayers may claim deductions for equipment, software, advisory fees, professional fees, and other business expenses.

Market evidence may also be relevant. Courts frequently consider whether comparable businesses dealing at arm’s length would have paid a similar amount for comparable goods or services. Although fair market value is often a useful benchmark, it is not the only consideration. In Bertomeu c. R., 2005 CarswellNat 7022, the Tax Court recognized that paying fair market value will generally support reasonableness, but paying more than fair market value is not automatically unreasonable where the surrounding circumstances justify the amount. Commercial circumstances, business risks, urgency, specialized expertise, long-term business objectives, or other legitimate business considerations may justify a higher payment.

The relationship between the parties is another important consideration. Transactions involving shareholders, family members, related corporations, or other non-arm’s-length persons often receive greater scrutiny because the parties have greater control over the amount paid. However, the existence of a related-party relationship does not, by itself, make an expense unreasonable. The relevant question remains whether the amount can be justified on commercial grounds.

As discussed above, Gabco Ltd. v. Minister of National Revenue illustrates that a related-party relationship does not, by itself, make an expense unreasonable. The key question remains whether the amount paid can be justified by the services received and the commercial benefit to the business.

At the same time, section 67 is commonly applied when the taxpayer appears to be motivated in part by non-business reasons, such as excessive salaries paid to family members. In Williams v. R., 2009 CarswellNat 294, the court recognized that section 67 may be used to reduce the quantum of expenses in those circumstances. The practical point is that related-party or family payments should be supported by evidence showing the actual services performed, the business purpose for the payment, and the commercial basis for the amount.

Taxpayers should therefore be prepared to demonstrate why the amount paid made business sense when the expenditure was incurred. Employment agreements, management contracts, invoices, time records, board resolutions, market comparisons, valuation evidence, and other contemporaneous documentation may all assist in showing that the amount was commercially reasonable if the CRA later reviews the deduction during an audit or tax reassessment.

“Many taxpayers lose perfectly legitimate business expense deductions not because the expenses were improper, but because they cannot demonstrate why the amount was commercially reasonable. Good documentation, objective support, and a clear business rationale often determine the outcome of a CRA audit.” 

– David J. Rotfleisch, Certified Tax Specialist and Canadian Tax Lawyer.

Common Business Expenses the CRA Frequently Challenges

Section 67 may apply to virtually any otherwise deductible business expense. In practice, however, CRA tax audits tend to focus on expenditures where taxpayers have significant discretion in determining the amount paid or where the parties involved do not deal at arm’s length. These situations often require taxpayers to demonstrate that the amount claimed reflects genuine commercial considerations rather than personal, family, or tax-planning objectives.

Management Fees

Management fees are among the most frequently challenged expenses under section 67. The CRA will generally examine whether the services were actually provided, whether the fees reflect the value of those services, and whether a comparable amount would have been paid to an independent service provider under similar circumstances.

The courts have recognized that there is no predetermined percentage or “acceptable” management fee. Each case depends on its own facts. In some situations, a management company may legitimately charge amounts exceeding what might appear to be fair market value because it assumes business risks, employs staff, leases office space, owns equipment, or performs broader management functions that provide substantial value to the operating business.

Salaries Paid to Family Members

Compensation paid to spouses, children, parents, or other family members is another common area of CRA scrutiny. A salary is not unreasonable simply because it is paid to a relative. The relevant question is whether the amount reasonably reflects the services actually performed.

Businesses should therefore maintain records showing the duties performed, hours worked, level of responsibility, experience, and contribution of each family member. Employment agreements, payroll records, job descriptions, and contemporaneous documentation can be valuable evidence if the deduction is later challenged during a CRA audit.

Related-Party Transactions

Section 67 frequently arises where payments are made between related corporations, shareholders, partnerships, trusts, or other non-arm’s-length parties. While related-party transactions are entirely permissible under Canadian tax law, they often receive closer scrutiny because the parties have greater ability to influence the price.

The existence of a non-arm’s-length relationship does not, by itself, make an expense unreasonable. Nevertheless, taxpayers should be prepared to explain how the amount was determined and why an independent business would have agreed to pay a comparable amount under similar commercial circumstances.

Travel, Meals, and Other Discretionary Business Expenses

Travel, meals, entertainment, conferences, luxury accommodations, and similar discretionary expenditures may also attract CRA attention, particularly where the business purpose is unclear or the amount appears excessive relative to the commercial benefit obtained.

In these situations, taxpayers should retain invoices, itineraries, meeting agendas, client correspondence, and other documents demonstrating both the business purpose of the expenditure and why the amount incurred was commercially reasonable.

Regardless of the category of expense, the underlying question remains the same. The CRA is not simply asking whether the expenditure occurred; it is asking whether a reasonable business person, acting only for legitimate commercial purposes, would have incurred that amount in comparable circumstances.

Pro Tax Tips – How to Reduce the Risk of a CRA Tax Reassessment Under Section 67

• The outcome of a section 67 dispute often depends less on the expense itself than on the taxpayer’s ability to demonstrate why the amount paid was commercially reasonable. During a CRA tax audit, simply showing that an expense was incurred is rarely enough. Taxpayers should be prepared to explain the business rationale for the expenditure and provide contemporaneous evidence supporting the amount claimed.
• The strongest evidence is usually created before the CRA ever begins a tax audit. Written contracts, invoices, board resolutions, engagement letters, payroll records, management agreements, valuation reports, market comparisons, correspondence, and other contemporaneous business records may all help establish that the expenditure reflected ordinary commercial practice. Where the expense involves compensation or management fees, records describing the services performed, time devoted, responsibilities assumed, and value provided to the business can be particularly important.
• Taxpayers should also document how the amount was determined. In many cases, maintaining evidence of comparable market rates, quotations from independent suppliers, industry benchmarks, or other objective pricing information may significantly strengthen the taxpayer’s position if the CRA later questions the reasonableness of the expense. Although market value is not the only measure of reasonableness, objective commercial evidence often carries considerable weight during an audit or appeal.
• Related-party transactions deserve particular attention. Payments between family members, shareholders, related corporations, trusts, or partnerships should be supported by the same documentation and commercial analysis that would ordinarily exist between arm’s-length parties. Taxpayers should avoid assuming that a legitimate business purpose alone will satisfy section 67. The amount itself must also be objectively justified commercially.
• Businesses should also ensure that expenses satisfy the other requirements of the Income Tax Act before considering section 67. For example, questions concerning the timing of a deduction, unpaid remuneration, or prepaid expenses may be governed by separate statutory provisions. Section 67 addresses only one issue—whether an otherwise deductible amount is reasonable in the circumstances.
• When the CRA proposes to reduce a deduction under section 67, taxpayers should carefully review the assumptions underlying the tax reassessment before responding. Documentary evidence, expert opinions, industry comparisons, and witness testimony may all play an important role in demonstrating that the expenditure reflected legitimate commercial considerations rather than personal or non-business motives.
• The best time to prepare for a section 67 challenge is before one arises. Maintaining thorough contemporaneous records and documenting the commercial basis for significant expenditures can substantially improve a taxpayer’s position during a CRA audit, an objection, or Tax Court litigation.
• Where the CRA questions the reasonableness of a business expense, obtaining advice from an experienced Canadian tax lawyer at an early stage can help taxpayers develop a stronger evidentiary record and maximize the likelihood of successfully defending their deductions.

“The question under section 67 is not whether the CRA would have spent the money. The question is whether a reasonable business person could justify paying that amount on legitimate commercial grounds. That distinction often determines the outcome of a tax audit.” 

– David J. Rotfleisch, Certified Tax Specialist and Canadian tax lawyer.

FAQs – About Section 67 and Unreasonable Business Expenses

Can the CRA deny a business expense even if it was genuinely incurred?

Yes. An expense is not automatically deductible simply because it was actually paid or incurred for business purposes. If the amount is otherwise deductible but is considered unreasonable in the circumstances, section 67 of the Income Tax Act allows the CRA to reduce or, in appropriate cases, deny part or all of the deduction.

What does “reasonable in the circumstances” mean under section 67?

The courts have explained that reasonableness is assessed objectively by considering whether the amount reflects ordinary commercial practice. The CRA is not permitted to substitute its own business judgment for that of the taxpayer. Instead, the question is whether a reasonable business person, acting solely for legitimate business purposes, could have agreed to pay the amount in similar circumstances.

Can the CRA challenge salaries paid to family members?

Yes, but paying a salary to a spouse, child, or other family member is not prohibited. The issue is whether the remuneration reasonably reflects the services actually performed. Businesses should maintain employment agreements, payroll records, job descriptions, and evidence of the work performed to support the deduction if the CRA reviews the payment.

Does paying more than fair market value automatically make an expense unreasonable?

No. Fair market value is an important benchmark, but it is not the only consideration. Depending on the circumstances, a business may reasonably pay more than market value because of specialized expertise, commercial urgency, business risks, long-term strategic objectives, or other legitimate business reasons. The taxpayer should be able to explain why the higher amount made commercial sense.

Can the CRA deny a deduction simply because my business decision turned out to be a mistake?

Generally, no. Canadian courts have repeatedly recognized that section 67 is not intended to punish poor business judgment. A business decision that ultimately proves unsuccessful does not automatically make the related expense unreasonable. The focus is on whether the amount was commercially reasonable when the expenditure was incurred, not whether the decision later proved profitable.

What evidence should I keep to defend my business expenses during a CRA tax audit?

Businesses should retain contracts, invoices, payroll records, board resolutions, engagement letters, management agreements, correspondence, market comparisons, valuation reports, and any other contemporaneous documents explaining how the amount was determined. The stronger the commercial evidence, the easier it will be to demonstrate that the expense was reasonable if challenged by the CRA.

What should I do if the CRA reduces my business expense under section 67?

A taxpayer should carefully review the CRA’s reasons for the reassessment and gather all documents supporting the commercial basis for the expenditure. Depending on the facts, additional evidence, expert opinions, industry benchmarks, or witness testimony may strengthen the taxpayer’s position. Because section 67 disputes are highly fact-specific, obtaining advice from an experienced Canadian tax lawyer at an early stage can significantly improve the taxpayer’s ability to challenge the reassessment successfully.

DISCLAIMER: This article provides broad information. It is only accurate 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 as tax advice. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.