Canadians are taxable on a number of categories of income and a set of specifically designated types of property. Although the Income Tax Act makes income of any kind taxable, the courts have been hesitant to look beyond the listed categories when imposing income tax. The categories are salaries, wages, business, and property income. Capital gains are taxable but they are not considered to be income (which is why they were tax-free until 1972). When a Canadian taxpayer earns business income or income from a profession, then in addition to having to report and pay tax on their profits, they also need to fill out a form T2125 for each of their business or professional activities.
What is a business? The general definition is anything that occupies a person’s time and efforts in pursuit of profit. There doesn’t need to be a profit, and where you suffer a loss you’re able to set off the loss against other income in the same year (or carry this loss back three years or forward 20 years). Where there is a personal element in the business activity, then an additional test applies. The business has to have a reasonable expectation of profit, otherwise the losses are not deductible and the income is not taxable. The Canada Revenue Agency seems to take the position that business losses result from activity that is not a business and any income is from business activity. It is up to you to prove them wrong in either case.
Form T2125 is part of your reporting requirements, though you can also use other types of financial statements. It provides important information to the tax man that allows them to determine whether you are likely reporting your income correctly (and to determine whether you should be audited). The form also helps you report your income and expenses for tax purposes. The information you have to provide is relatively lengthy. The first section is used to identify you and your business or professional activities. Part 1 of the form deals with business income (if you have professional income, you have to till out Part 2). Part 3 requires you to set out your gross business or professional income, which includes the inclusion of any reserves taken the in preceding tax year. Parts 4, 5, 6, 7, and 8 allow you to deduct the cost of goods, expenses, and make certain other adjustments to determine your net income (there are a total of 19 parts, some or all of which may also apply to your circumstances). Most of your deduction will be expenses that are reported in Part 5. Expenses include such items as office expenses, supplies, legal fees, accounting fees, interest payments, insurance costs, and meals and entertainment expenses (this is not a complete list of allowable expenses).
Make sure to either fill out this form or to provide consistent and accurate financial statements as part of your return to avoid the headache of having to deal with the tax man. It is always best to have a tax professional help you prepare your financial statements to avoid unintended mistakes that trigger an expensive audit.
Case Study
Instead of owing significant amount of taxes, Sam reduced it to zero. I highly recommend to hire Sam for this type of audits and any CRA problem.
