CRA Crackdown on Small Business Income

Tax filing season is officially over and that means it’s officially tax audit season. And that can be very expensive. For example, you may have heard the story of the $250,000 owing in back taxes by a campground in Ontario.

In this case, CRA has interpreted the income to be “rental income” from property, rather than “service income” which qualifies for the small business rate. They may or may not be right.

It’s true that income qualifying for the small business tax rate is income that stems from capital employed or risked in the business, and that this does not include income from “property” which is not connected to, or necessary to, sustain the corporation’s business operations. Also excluded is income from a specified investment business carried on in Canada.

These definitions are outlined in CRA’s IT 73 R6, which interprets Section 125, subsections 14(1), 123.4, 129(4), and 129(6), the definitions “active business” and “specified shareholder” in subsection 248(1), paragraph 18(1)(p), subparagraph 12(1)(e)(ii) of the Income Tax Act and section 6701 of the Income Tax Regulations.

The property must be “incident to” an active business, or held primarily to gain or produce income from an active business, in order for the income to qualify for the small business tax rate. Otherwise it is a question of fact whether the property is used primarily in an active business, and the onus of proof is on the taxpayer. CRA’s interpretation bulletin goes on to say that the factors to be considered in whether or not the property is used in an active business include:

1. The actual use the asset is put to in the course of earning income from the business
2. The nature of the business
3. The practice in the particular industry

Looking to jurisprudence for further guidance, the Supreme Court of Canada in Ensite Limited v. Her Majesty the Queen, [1986] 2 CTC 459, 86 DTC 6521, “held that the holding or using of property must be linked to some definite obligation or liability of the business and that a business purpose test for the use of the property was not sufficient. The property had to be employed and risked in the business to fulfil a requirement which had to be met in order to do business.”

The case defined risk as “more than a remote risk. The property had to be integral to the business operations or the financing of the business to be considered to earn income from an active business.” Another way to look at it, if the business would be “destabilized”  by withdrawing the property, clearly the income from it is active business income.

These are the issues to be argued in CRA’s recent activities related to campgrounds. Each case, of course, is different; however, these interpretations provide guidance to taxpayers and their advisors, as well as to the CRA itself and to courtrooms hearing appeals.  With tax audit season in full play, a tax professional who has well-honed research skills provides an additional value proposition in cases like these.

Additional Educational Resources: Tax Services Specialists who train through Knowledge Bureau are required to add a research component to their studies through access to EverGreen Explanatory Notes, an 800-topic online research library that is connected to all the relevant sections of the Income Tax Act for each topic, as well as to CRA’s publications on the matters.

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