Several Reasons CRA Could Deny Small Business Expense Deductions

Owning a business brings with it a variety of business expense deductions that are crucial to earn revenue. The end objective of incurring these expenses is to earn a profit. In the initial few years, your business may not generate profit. However, it must earn profit at some point, or there is no point in doing the business.

The key reason for business losses is higher expenses. The Canada Revenue Agency (CRA) allows businesses to deduct reasonable and incurred expenses to generate revenue. However, business owners should maintain detailed records of each expense and keep payment receipts for at least six years. The CRA can reassess your tax filings over the next three years and demand financial statements, documents, and records that prove the expense was incurred for business purposes. The CRA can also go beyond the typical three-year reassessment period and reassess your records if they have reasonable grounds to believe willful default, fraud, or tax avoidance.

In this article, we will discuss a case in which a small business owner was denied business expenses for a nine-year-old tax return.

A Business Case of Unrealistic Business Expenses

Here is a background of the business case. A taxpayer opened a “financial consulting” business in 1999 to sell mutual funds and life insurance. In all these years, the business only made losses as expenses exceeded revenue significantly. However, the revenue never exceeded $1,900. Revenue was below $800 for nine years. There was a gross mismatch as the impact of the rising expenses was not visible in revenue. 

The trigger point was in 2011 when the business reported its weakest revenue of $27 and highest business of over $19,000. Such trends encouraged the CRA to go beyond its three-year reassessment period and assess the 2011 tax year business expenses. 

After the reassessment, the CRA allowed the taxpayer to deduct expenses of $3,715, resulting in a business loss of $3,688. Why did the Agency deny $15,951 in business expenses?

Let’s dive into the business expenses and see if they are reasonable. Expenses of over $19,000 in 2011 comprised significant meals and entertainment expenses, travel expenses, office expenses, motor vehicle expenses, and capital cost allowances on vehicles.

Travel Expenses

The Tax Court identified that the taxpayer travelled 4,600 kilometres for business purposes but secured no new clients. Among the travelled kilometres were five trips in December alone, of which one trip was between Christmas and New Year and one on a Saturday.

Learning: Vehicle expense is the key target of the CRA. The Agency and the tax court can go into depth to identify misrepresentation. Details like the date and kilometres travelled are not enough as the CRA and the tax court can ask you about a trip taken nine years ago. Hence, it is a good practice to write a description of the travel stating the purpose of travel, client name, location, distance travelled, date, and time. The intent should be clear if you look back at the transaction even after 10 years.

Most importantly, do not claim business expense deductions for personal travel, even for a small amount. While it may save you a few dollars in tax now, you might have to pay a hefty penalty later if the CRA catches you.

Meal, Entertainment, and Other Expenses

The taxpayer spent hundreds of dollars on meals to earn a $27 commission. He even spent over $200 on birthday cards, birthday cakes, children’s T-shirts, tickets to a Christmas show, ice cream, and alcohol, claiming they were gifts to clients and their children. There were a few expenses, such as the purchase of an iPod and the Canada Border Services Agency import fee. The taxpayer did not explain how these expenses were related to the business, given that he had no clients outside Canada. 

The Tax Court denied these business expense deductions, stating “these gifts were motivated primarily by personal relationships rather than business considerations … (and) were not incurred for the purpose of earning income.”

The appellate court concluded these business expenses unreasonable as a “commercially minded businessperson would not have incurred such expenses in the (taxpayer’s) circumstances.”

Learning: No business owner in a sound mind would incur such hefty expenses if they are not generating sufficient revenue from the clients. Entertainment and gift expenses should be reasonable. Having receipts cannot justify the business intent. Hence, reviewing your business expenses at the end of the month or quarter and analyzing them from the CRA’s perspective can help you avoid claiming unreasonable business expenses and only those that justify the intent to grow the business.

Business Expense Deductions on Rental Income

The same case also had another income source. The taxpayer owned several apartments, which he rented to his sons, which were below the fair market value. He claimed property expenses and reported rental losses from these properties, further reducing his taxable income.

The Tax Court concluded the taxpayer’s rental activity was personal and not a source of income, denying him deductions for the expenses incurred on those properties.

Learning: Even if you rent your apartment to your children, you should charge the rent at the market rate. Only when you earn a reasonable rent can you deduct maintenance and other expenses and claim them. The intent should be to earn profits.

Contact KSSP Partners LLP in Markham to Help You with Tax Filing

A professional accountant is well-versed with the CRA’s definitions and assessment and can help you claim reasonable business expenses and comply with tax laws. Tax professionals and accountants at KSSP Partners LLP help you claim the tax benefits you are eligible for and not misuse them, thereby making your business tax efficient. To learn more about how KSSP Partners LLP can provide you with the best accounting and tax planning expertise, contact us online or by telephone at 289-554-5997.