In Canada, a business is taxable on the profit it makes in its tax-year. You don’t have to be an accountant to know that “profit” means “revenues” less “expenses”. Though this seems easy in theory, the practice of determining what counts as “revenues” and when that is included in income, what are deductible “expenses”, and when they are deductible can be complex. This article will look at one of the conditions that an expense has to meet under the Income Tax Act before it is deductible from income.
There are a number of conditions to qualify an expense as reasonable, including that the amount of the expense has to be “made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property”, cannot be incurred to gain exempt income, and that it cannot be on account of capital or depreciation unless specifically allowed by regulations. There are many other conditions for consumer-based businesses. One such condition is in section 67 of the Income Tax Act. This rule applies to an expense that is otherwise deductible. Section 67 states that no amount is deductible at all except to the extent that the expense and the amount of the expense is reasonable in the circumstances.
What does it mean for an expense to be reasonable in the circumstances and what is the outcome if the expense is not reasonable? This was the very problem a Mr. Peach encountered in a recent Tax Court of Canada Decision. Mr. Peach deducted a number of expenses, including meals and entertainment expenses, motor vehicle expenses, and business taxes and fees, and office expenses. These expenses are usually deductible. In this case, however, the Canada Revenue Agency took the position that the expenses and their amounts were not reasonable.
So, what is reasonable? First, an expense is not unreasonable just because it turns out to be the outcome of poor business judgment. It also doesn’t matter whether expenses exceed revenues and the business has a loss. The test the courts will apply is one that requires them to answer this question: “Would no person of business have paid such an amount in the circumstances of this specific taxpayer?”. If the answer is yes, then the amount is unreasonable.
The outcome depends on what about the expense is unreasonable. If the incurring of the expense itself was unreasonable, then the entire amount is not deductible. If, however, it is the amount of the expense that is unreasonable, then a court will reduce the deductible amount to what is a reasonable amount. You get less of a deduction, but at least you get a deduction of something.
