Business Expense Limitations
In an earlier article, a list of business expense categories used by the CRA was provided (see the article HERE). This is the second article in the series that hopes to help small business owners figure out what expenses are deductible and which ones are not. In this article, we are going to start by looking at the most common limitations on the deductibility of expenses in the Income Tax Act. One general limitation discussed in a separate article is that the expense has to be reasonable in amount and in substance (see that article HERE).
So, once you have removed the HST/GST portion, determined that the expense is reasonable, and that it is something that should be deducted to get to “profit”, are you good to deduct? The answer is “No!”. The Income Tax Act has a series of limitations that apply to all expenses with respect to business and property sources of income. There are much more restrictive limits for employment expenses, but that is for another article. The most common general limitations on business expenses, or tax deductions, are found in section 18 of the Income Tax Act. There are too many limits to address in one article, so we are going to focus on the most common ones that small businesses encounter.
The most important limit is also the first one listed in section 18. It says that NO amount is deductible unless the outlay was made or the expense was incurred by the taxpayer (being the person whose business or property profit we are calculating) “for the purpose of gaining or producing income from the business or property”. There is a lot to digest in these few words. The most important thing to notice is that it is a “purpose” test, not a “results” test. So long as the “purpose” of incurring the expenditure is to make income, it doesn’t matter whether that specific expenditure produces revenues or a profit (or even if the business itself is profitable). This makes sense since a business can have a loss year one tax-year and a profitable year in another tax-year. If expenses were not deductible unless there was a profit directly related to the expense, a business could never suffer losses. In other words, there is no need to show a causal connection between an expense and revenue or income. That said, this is not purely subjective. The expense must be part of the business – somehow related to the operations, transactions, or services by which the business earns revenue. If an ordinary person in that line of business would have incurred the expense as part of the business, then the purpose test is met.
The second limitation on what expenses are deductible relates to capital expenses. Despite accounting practice, you cannot deduct fully and all at once any expense that is “capital” in nature or that relates to “depreciation, obsolescence or depletion”. Where you incur an expense that gives you a lasting benefit ? where the expense is “capital” and not just operational ? then all deductions are only those the allowed by the Income Tax Act. Most of this is covered by the Capital Cost Allowance system that will be discussed in another article.
The next limit on expense deductibility we consider is that you cannot an expense that relates to producing exempt income. This makes sense. If the profits are not going to be taxable, why would the expenses (or resulting losses) be deductible?
The fourth limitation is one that many small business owners get caught by. The law doesn’t allow any deduction for “personal or living expenses”. The only exception to this is any personal or living expenses that are “travel expenses” incurred while away from home and traveling on business. There are some other expenses that are “personal and living” expenses that are specifically allowed. These specific expenses will be covered in the final part of this article series (coming soon).
The fourth limitation is one that many small business owners get caught by. The law doesn’t allow any deduction for “personal or living expenses”. The only exception to this is any personal or living expenses that are “travel expenses” incurred while away from home and traveling on business. There are some other expenses that are “personal and living” expenses that are specifically allowed. These specific expenses will be covered in the final part of this article series (coming soon).
- Is the expense widely accepted in the business community as a business expense?
- Is the deduction for this expense one that is ordinarily allowed as a business expense by accountants?
- Is the expense one that is regularly incurred by others that are involved in the same business?
- Would this particular expense have arisen if you were not involved in the business you are involved in?
Where the expense would have been incurred if you were not engaged in the business or, in other words, where the need for the expense exists independent of the specific business, then the expense is most likely one that is “personal or living”. A good example of this is ordinary clothing as compared to specific uniforms or specialized clothing. Whether or not a person is involved in any business or not, they will have to pay for clothing. This is just one of those expenses of living that has to be incurred no matter what. However, some items of clothing are either required as a uniform for a business, and therefore cannot be work elsewhere, or are specialized clothing (reflective vests, safety equipment, heavy duty work wear, etc.) that a person would not buy absent the specific needs of a business. The cost of this clothing would be deductible (though most likely the cost would be a capital expense). Another common example is the cost of travel to and from your place of business. Everyone needs to get to and from work, no matter what their work is (or whether they are employed or in business), and the cost of getting to work (and the choice of the transportation method) is a personal one.
To summarize so far, in order for an expense to be deductible it:
- Must be reasonable,
- Must be incurred for the purpose of producing income,
- Must NOT be a capital expense,
- Must NOT be related to earning exempt income, and
- Must NOT be a personal or living expense.
The next article will discuss limits on a set of specific expenses.