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Update of Proposed legislation under the Income Tax Act (Canada) Regarding Reasonable Expectation of Profit

In October 2003, the Department of Finance released legislative proposals regarding the deductibility of interest and other expenses for income tax purposes.  According to the government, the proposals were drafted in response to certain court decisions that departed significantly from what was believed to have been the law on this issue. 

Generally, expenses incurred to earn income from property or business are deductible under the Income Tax Act.  The CRA has always interpreted income to mean net revenue and capital gains were excluded from the calculation.  A number of recent court decisions offered an alternative approach that challenged this interpretation.  These decisions interpreted income as gross revenue and included capital gains as part of the calculation.  Because of the uncertainty these diverging view points created, the government believed it was necessary to clarify the law and ensure a consistent approach to this issue by introducing proposed section 3.1.

Essentially, under proposed section 3.1, a taxpayer would be able to claim a loss from business or property if it is reasonable to expect that a profit would be realized for the period that the taxpayer has carried on, and can reasonably be expected to carry on a business or has held property.  The proposal specifically excludes capital gains and losses from the calculation of profit. 

After announcing the draft proposal, the government provided a public consultation period that was extended to August 2004.  A number of concerns were raised during the consultation period regarding the structure of the proposal.  The main concern was that the introduction of an objective “reasonable expectation of profit” test into the statutory language of the Act would inadvertently limit the deductibility of ordinary business expenses.  Specifically, there was a concern that the proposal would deny losses even where there was a reasonable expectation at the beginning of a venture that subsequently did not generate profit.  Since disallowed losses could not be carried forward this would be a disadvantage to many start-up businesses.

On February 23, 2005, in response to these concerns, the Department of Finance announced that it would develop “a more modest legislative initiative” that would still achieve its goals.  Unfortunately, with the change in government leadership in 2006 the proposal was placed at the bottom of the new government’s priority list.  It is uncertain when this draft legislation will be enacted nor what form it will take.  However, the Department of Finance has provided reassurance that the intention is only to return the law back to the status quo.  Prior to enactment, the Department will update the proposal to reflect the concerns expressed during the consultation period.

The Department still continues to informally receive comments on the draft legislation.  Once the Minister of Finance takes a position on the proposal the issue may become open for official comments but this has not been decided yet.

There has been no government announcement indicating whether the effective date of January 1, 2005, will be changed.

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Proposed Changes to Dividend Taxation

On June 29, 2006, the Department of Finance released draft legislation and explanatory notes regarding changes to eliminate double taxation of large corporation dividends.  The draft will introduce a number of new provisions including subsection 249(4.1) which will provide a deemed taxation year-end that applies any time a corporation becomes or ceases to be a Canadian-controlled private corporation (CCPC), as defined under the proposed legislation, other than by an acquisition of control.  According to the explanatory notes this change will prevent a corporation from being treated as CCPC for part of a taxation year, which will allow better access to claim the small business deduction.  The change also affects the tax treatment of eligible dividends, as defined under the proposal, with respect to the timing of inclusion in income.  If enacted, the proposed amendment will be effective as of January 1, 2006. 

Because of its retroactive application, tax practitioners and clients are concerned about the implication for transactions executed or substantially completed prior to the release date of the proposal and after the proposed effective date.  On August 3, 2006, I spoke with representative at the Department of Finance about whether the department had provided any advance notice about the proposed changes and if the Department considered the impact the changes would have on transactions occurring before the release date. 

The representative confirmed that prior to June 29, 2006, there were no government releases to alert the public about the proposed amendment.  He indicated that many taxpayers have communicated their concern to him about this issue and he intends to recommend that the Department amend the proposed legislation to provide for a grace period.  However, until this issue is addressed, the representative suggested that taxpayers should consider whether making an election under proposed 89(11), which essentially allows corporations to choose not to be treated as a CCPC, can be used an alternative to counter the effect of the new deemed year-end rule.

The representative is not certain when the legislation will be enacted but expects it to be sometime in the fall - shortly after the Department’s review period, which ends September 15, 2006.  For more information on this proposal, you can contact Ryan Hall at 613.996.5155 until August 18, 2006.  After this date, all enquiries should be directed to Lawrence Purdy at 613-996-0602.

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