Understanding Profit, Business Income, and Trade Nature in Canadian Tax Law

Since Capital Gains in Canada have a Tax inclusion rate of 50% (meaning that only 50% of the capital gains is taxable), it is important for the CRA and the Income Tax Act (ITA) to define the nature of trade of a business in order to determine how the profit of certain transactions is taxed (e.g. as regular business income vs capital gain)

Adventure or Concern in the Nature of Trade

The legislation in Canada encompasses the definition of business to include "adventure or concern in the nature of trade," aimed at taxing gains from single transactions as fully taxable business profits.

Notable instances include flip transactions where property is purchased with the sole intention of immediate selling for quick profit.

Single transactions are compared with individuals conducting a business of selling similar types of property, such as commodities or shares, held for a short duration.

Elective Option - ITA 39(4)

Taxpayers can elect to treat the sale of securities on a capital account for the year and subsequent years under ITA 39(4).

This option is available to Canadian resident taxpayers, although ITA 39(5)(a) excludes elective capital treatment for specific sales if the seller acts similarly to a trader or dealer in securities.

Understanding Profit

While profit is not explicitly defined in the ITA, court interpretations establish it as a legal question rather than an accounting one. Generally Accepted Accounting Principles (also known as GAAP) serve as interpretative aids rather than legal rules.

The idea is to obtain an accurate depiction of the taxpayer's profit for a given year in order to derive the basis of the income tax that will be assessed.

The 9-12-18-20 General Rule

The reconciliation or conversion of accounting income to an acceptable amount for income tax purposes involves:

• ITA 12: Adding income amounts to business or property income.

• ITA 18: Imposing general limitations/restrictions on deductions.

• ITA 20: Permitting deductions.

  Example: Specific provisions, such as ITA 67.1, reduce meals and entertainment expenses by 50%.

Business Income - Inclusions (ITA 12)

Business income is primarily determined on an accrual basis (like the matching principle of GAAP), with farming and fishing businesses eligible to use the cash basis under ITA 28.

ITA 12(1)(b) codifies the accrual basis, including amounts received or receivable for services or products.

Amounts received in advance, as per ITA 12(1)(a), are included in business income, with a reserve allowed to offset amounts received (except refundable deposits) under ITA 20(1)(m).

Reserve Concept - ITA 20(1)(m)

Th ITA introduces a reserve concept which:

1. Allows for the inclusion of the entire amount received in advance in income (ITA 12(1)(a)), and

2. A separate claim for reserve of the same amount is allowed (ITA 20(1)(m)), where if deducted in one period, it must be included in income in the following period, though

3. No reserve is permitted when the amount has been earned.

Quality of Income - ITA 9(1), 12(1)(a), & 12(1)(b)

• The "quality of income" test determines inclusion in business income, where an advance (receiving payment for a future service or product) has the quality of income if:

  • The business has an absolute and unconditional right to the amount.

  • There are no restrictions, contractual or otherwise, on its disposition, use, or enjoyment.

• This legal determination influences when income is earned and effectively forms part of the profit under ITA 9.

Understanding these concepts is essential for taxpayers and businesses to ensure compliance with Canadian tax laws and make informed financial decisions. For personalized assistance and expert guidance, contact Toro Financial today to navigate your tax and financial concerns with confidence.