CHAPTER 4Income from Business: General Concepts and Rules

Problem 1[ITA: 9; IT-218R]A piece of land was purchased by Yacumflastor Corporation Ltd. for the purpose of constructing a high-rise

residential building. Plans were made for the development of the property, surveys were made and the land was stripped and excavated in preparation for construction. Subsequent to this work on the land, it was determined that the location was not suitable for the intended purpose, due to heavy truck traffic in the area. As a result, the property was listed for sale with the realtor who acted in the original purchase. The sale at a substantial profit took place approximately six months from the purchase.

The corporation had been newly formed when the above land was purchased. At about the same time, another piece of land was purchased and was developed into a commercial/industrial plaza which the corporation continues to own as a rental property. The principal shareholder of the corporation, Jake Yacumflastor, owns and operates an electrical contracting business.

The Articles of Incorporation of the corporation contain the following statement of objects:... to purchase, lease, acquire, hold, manage, develop, operate, pledge and mortgage, either absolutely as owner or by way of collateral security or otherwise, alone or jointly with others and either as principal or agent, property, real or personal, and assets generally of any and every kind of description.

No mention is made of the purchase and sale of land as a business activity.—REQUIRED

Write a memo for the Yacumflastor Corporation Ltd.’s file evaluating the issue of whether the sale of the land should be treated as a receipt of income or capital gain for tax purposes. Arrive at a conclusion consistent with your analysis of the facts, but indicate the basis for any areas of potential opposition to your conclusion.

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Introduction to Federal Income Taxation in Canada

Solution 1Intention of the Taxpayer

(A) Primary intention: The corporation intended to construct an apartment building on the property, not to purchase the property itself for resale at a profit. Unexpected circumstances resulted in the sale of the property. These statements of intention must be substantiated by facts which can be observed objectively, as discussed below. (B) Secondary intention: The question of whether the corporation intended, at the time of purchase and as a motivation for the purchase, to resell the property at a profit if the primary intention was frustrated must be answered by reference to other factors discussed below.

Factors Used to Substantiate the Intention of the Taxpayer(A) Relationship of the transaction to the corporation’s business: The corporation was not normally in the

business of buying and selling land. This was a relatively new corporation at the time of the transaction. In addition to the land which it sold, it purchased another property which it has developed into a commercial/industrial plaza and which it holds as a rental property. Furthermore, the principal shareholder of the corporation owns and operates an electrical contracting business and, thus, cannot be said to be in the business of buying and selling land.

(B) Nature of the activity surrounding the transaction: The transaction involving the sale of the property should not be considered of a business nature or “an adventure in the nature of trade.” The sale was made only after it was determined that the property location was not suitable for development into an apartment building. It was listed for sale with the realtor only at that time and not immediately after purchase. It could be argued that the minor improvements made were to make the property more marketable for resale purposes.

(C) Type of asset: The land was to be developed for an apartment building used for rental purposes and, hence, would have been considered a capital asset rather than inventory. Plans were made for the development of the property to the extent that surveys were made and that the land was stripped and excavated in preparation for construction. The fact that no income was ever earned from the property as a capital asset could be used to suggest it was held as inventory.

(D) Number and frequency of transactions: Since this is a new corporation and the transaction in question was the first of its nature, there is no track-record on which to base an assessment of number and frequency despite a short (i.e., six-month) holding period. As a result, this should not be a determining factor in this case.

(E) Articles of incorporation: There is nothing in the Articles of Incorporation to suggest that the corporation can engage in the purchase and resale of land as a business activity. On the other hand, the articles are very broad and might be interpreted to encompass this type of business activity.

(F) Other factors: IT-218R, paragraph 3 suggests other factors which might be considered in the evaluation of real estate transactions, including:

(i) the feasibility of the taxpayer’s intention;(ii) the geographical location and zoned use of real estate acquired;(iii) the extent to which borrowed money was used and the terms of the financing;(iv) the length of the holding period (relatively short, i.e., 6 months, in this case);(v) factors which motivated the sale.

ConclusionFrom the foregoing analysis of the facts, it is reasonable to conclude that the profit realized on the sale of the

property was a capital gain. The intention to develop the property as an income-producing capital asset, in the same manner as the development of the other property, is substantiated by the nature of the transaction, the type of asset and the Articles of Incorporation.

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Solutions to Chapter 4 Assignment Problems

While it may be possible to argue that the corporation had a secondary intention to sell the property at a profit, if the primary intention of developing it as a capital asset was frustrated, the evidence is not strong for that argument. Such a secondary intention is best supported by evidence of a person, such as a realtor, who is knowledgeable in the real estate market. Neither the corporation nor its principal shareholder was engaged in the real estate business or could be said to have specialized knowledge of real estate markets, unless the electrical contracting business can be considered to provide special real estate knowledge and insights. Furthermore, the property was not listed or made available for sale immediately after purchase, but only after the location was found to be unsuitable.

It is possible to regard the amount of development activity as consistent with holding the land as inventory for resale, but relative to the other facts supporting a capital transaction the income receipt alternative is less likely.

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Introduction to Federal Income Taxation in Canada

Problem 2[ITA: 18(l)(a), (h); 248(1)]The taxpayer, in 1959, purchased 200 acres of property in the Calabogie area of Lanark, as a holiday

property for himself and his family. In 1961 it became their principal residence. He worked in Ottawa, both at that time and in the subsequent years; initially he commuted between the Lanark property and his Ottawa job on a daily basis. In the early 1970s he began living in Ottawa during the week and commuting home to the property only on weekends. When the property was first purchased, there was an old brick house on it which was not suitable as a residence for the family. A new house (referred to in the evidence as the D.V.A. house) was built; the family moved into it. It is clear that the family’s lifestyle was such as to enjoy the rural location.

In 1974 the taxpayer decided to turn part of the property into a campground; 8 serviced campsites and approximately 12 unserviced sites were created for this purpose. There was as well room for at least 10 other unserviced campsites more or less immediately available and potential for expansion to a much larger number (e.g., 100). Outhouses were built; a trout pond constructed; and the requisite service roads installed. The tax treatment of the expenses incurred with respect to this construction is not part of the dispute in this case.

After these initiatives had been taken, sometime towards the end of 1975 or the beginning of 1976, the taxpayer sought the advice of a consultant with the Ontario Ministry of Tourism, a Mr. Bingham. The advice sought was with respect to the possibility of developing the campground and obtaining a business loan for this purpose. The taxpayer had applied in early 1975 for a loan and was turned down in September of that year.

The taxpayer’s consultations with Mr. Bingham in the later half of 1975 and beginning of 1976 led to suggestions for the development of the campsite through the construction of additional facilities: additional serviced sites; proper toilets; laundry facilities; a store on the property; a swimming pool; an activities building which might be used by the campers in bad weather. The taxpayer’s accountant, Mr. McCoy, in early 1976 prepared projections as to the proposed profitability of the venture if the proposed development took place. These projections showed losses in the first year (1976–77) but a profit thereafter. The projections were based on information given to Mr. McCoy by the taxpayer and they envisaged the obtaining of a $280,000 loan. The taxpayer applied to the Eastern Ontario Development Corporation, in 1979, for a loan ($45,000, not $280,000). Mr. Bingham was asked to evaluate the loan application from the Department of Tourism’s point of view. He was asked to consider: whether the taxpayer had the management capability to effect and operate the proposed development; whether there would be any negative effects on competitors in the area if the development took place; whether the taxpayer’s marketing plans looked reasonable. Mr. Bingham’s evaluation did not involve any financial analysis of the application. Mr. Bingham recommended that the loan application go forward for the next step, evaluation by the Eastern Ontario Development Corporation. The taxpayer was unable to obtain the loan, because the Eastern Ontario Development Corporation’s funds are new money for new projects.

The taxpayer purchased a “pre-fab” house for $40,000 which was constructed across the road from the D.V.A. house. The family moved into that house in January of 1980. The taxpayer contends that he had decided to proceed with the plans for the development of the campsite by turning the D.V.A. house into the general activities building envisaged in the projected development. He states that he planned to add laundry facilities, toilets, etc., thereto. During 1980, the taxpayer rented the D.V.A. house to his daughter for $100 per month. This was not sufficient to cover the mortgage costs of the property. In May of 1980 the taxpayer had a massive heart attack. He was incapacitated until at least September of that year. The taxpayer continued to charge the mortgage expenses of the property as a business expense.

The profit and loss record of the taxpayer’s business never showed a profit from the first year of its operation, in 1975 to 1985. The taxpayer has consistently reported losses: $7,985.54, $8,676.84, $8,383.37, $14,491.57, $24,414.44, $14,350.77, and $14,508.35 for the 1977–1983 years, respectively. The gross income for the campground itself for the years 1977 to 1980 was $86, $134, $258, and $520, respectively. After 1980, the campground income was reported in a combined fashion with that received from the cottage and farmhouse property; therefore, it cannot be separately identified. The evidence is sketchy with respect to the renting of the cottage, the farmhouse and the D.V.A. house. That which exists does not show a vigorous and concerted effort to run a business. The D.V.A. house, as well as being rented to the taxpayer’s daughter for $100 per month in 1980, was rented during a few of the winter months in 1981-82 to some loggers and for approximately six months in 1984 to some miners who were prospecting in the area.

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Solutions to Chapter 4 Assignment ProblemsCamp Coupland was listed in a Government of Ontario camping brochure published for the 1981 season and

the taxpayer had had some calling cards made with Camp Coupland, the address, a map and rates listed thereon. No expenses for advertising of the Camp were included in his 1975–1985 tax returns.

—REQUIREDDetermine whether expenses incurred by the taxpayer during the 1980 and 1981 taxation years are business

expenses that are deductible for tax purposes.

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Introduction to Federal Income Taxation in Canada

Solution 2[Reference: Coupland v. The Queen, 88 DTC 6252 (F.C.T.D.)]The following has been edited from the Court’s decision (which preceded the Stewart decision, 2002 DTC

6969 (S.C.C.)).The issue to be determined is purely one of the fact: did the [taxpayer] during the years in question

incur the expenses for the purpose of producing income from a business, that is, was he engaged in an activity with a reasonable expectation of making a profit therefrom. … … I could not conclude on the basis of the evidence in this case, that the expenses in question were incurred by the taxpayer for the purpose of producing income from a business. I do not conclude that the activities in which the [taxpayer] was engaged were carried on with a reasonable expectation of a profit. …

My conclusion that the [taxpayer’s] activities were not carried on with a reasonable expectation of profit, is based on the reasons which follow. The profit and loss record of the [taxpayer’s] business never showed a profit from the first year of its operation, in 1975 to 1985. …

With respect to the taxpayer’s training, I have no doubt that the [taxpayer] had adequate managerial and the other abilities to develop the campground and run the operation had he chosen to do so as a serious business venture, and, had he had the capital to do so. His past experience in various managerial functions, albeit not in the private sector, and his obvious ability to deal well with people would have made him an ideal candidate to operate such a business. And, in any event, the running of a campsite is not a high skill occupation.

While I have no doubt that the [taxpayer] had the experience and ability to run a campground operation as a business, he was not in fact doing so. He was not on the property much of the time. He had a full-time job in Ottawa during the whole period and only returned to the Lanark property on weekends. There is no evidence of a concerted effort to try to ensure a full occupancy rate of even the limited number of campsites which were in existence. (By full occupancy I mean what would constitute average occupancy in the industry.)

There is no evidence of any concerted advertising of the campground property. … There is no evidence of any definite or specific plans for conversion of the house — merely the [taxpayer’s] vague statement that this was intended. … … Mr. Bingham’s evidence was that the business was marginally viable in 1976 and that with the expansion of the facilities, the business could become truly viable. … I have no doubt that the operation of a campground in the area might be a viable enterprise — especially had the suggested improvements been made. But, the issue is whether the business, as the [taxpayer] was operating it, was one which was being run with a reasonable expectation of profit. I do not think it was.Note that the case of Tonn et al. v. The Queen, 96 DTC 6001 (F.C.A.), has commented on the applicability

of the reasonable expectation of profit test. In that case, the Federal Court of Appeal indicated that where there is no personal benefit element, that is, the venture is of a purely commercial nature, the application of the test may not be appropriate. In the particular case at hand (i.e., the Coupland case), however, there was a personal element to the fact situation, since the property was purchased as a holiday property for the taxpayer and his family and it became their principal residence. Later, a house on the property was occupied by the taxpayer’s daughter at a rent that was not sufficient to cover the mortgage costs of the property. Therefore, it would appear that under this fact situation, application of the test is appropriate.

The Supreme Court of Canada, in the Stewart case, established a “pursuit of profit” source test, which requires analysis, where there is some personal or hobby element to the activity in question. Since a personal element was found to exist in this case, the question of whether the taxpayer intended to carry on a business for profit must be addressed and it was, as is evident from the above excerpts from the decision.

One approach to addressing the issues of this case is to apply the checklist of factors in Exhibit 4-2 in Chapter 4 of the text to the facts of this case, to the extent that they are known. The Exhibit is reproduced here for that purpose. Recognize, however, that this list of factors was developed from U.S. jurisprudence which has no legal precedent status in Canada.

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Solutions to Chapter 4 Assignment Problems

Exhibit 4-2Checklist of Factors Used to Determine the Existence of a Reasonable

Expectation of Profit or of Operating in aBusinesslike Manner

(1) Manner in which activity is operated:(a) activity held out to community as a business(b) activity operated in a businesslike manner(c) operated in manner similar to comparable profitable businesses(d) unsuccessful methods discontinued and new ones adopted(e) formal books and records maintained(f) separate bank account maintained(g) record keeping system provides for the determination of segment profits and relevant costs(h) detailed non-financial records maintained(i) operating methods changed to improve profitability(j) level of advertising or promotion undertaken(k) development plan formulated and followed(1) scale of operations sufficient to be profitable.

(2) Elements of personal pleasure or recreation:(a) taxpayer obtains personal pleasure from the activity(b) facilities are utilitarian(c) conduct of activity involves social or recreational functions (apart from the activity itself)(d) long-time interest in activity as a hobby(e) operating methods constrained by personal motives(f) personal use separately accounted for.

(3) Expertise of the taxpayer or his advisers:(a) prior experience in the activity(b) profit potential determined prior to entry(c) pre-entry advice (or prior preparation) sought and followed(d) post-entry advice sought and followed(e) taxpayer belongs to business-related associations(f) new or superior techniques developed.

(4) History of income and loss:(a) average ratio of receipts to disbursements(b) percentage years receipts less than disbursements(c) average magnitude of losses(d) trend of losses declining(e) number of years activity was operated(f) losses due to circumstances beyond taxpayer’s control(g) percentage of years with profits(h) reasonable start-up period

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Introduction to Federal Income Taxation in Canada(i) trend of gross revenues.

(5) time and effort expended:(a) competent and well-informed manager employed(b) competent labour employed(c) average time spent on activity by taxpayer(d) taxpayer withdrew from another business to devote most of his/her time to the activity(e) taxpayer did physical labour.

(6) Financial status of taxpayer:(a) taxpayer’s average income before activity loss(b) extent of tax savings from net losses(c) average ratio of activity losses to other income(d) taxpayer maintains an extravagant standard of living(e) majority of taxpayer’s other income is from investments(f) extent of other net assets of taxpayer(g) amount of capital invested in the operation.

(7) Amount of occasional profits:(a) ratio of average profit to average loss(b) amount of largest profit earned(c) ratio of net losses to net assets.

(8) Sale or discontinuance of activity:(a) activity sold or discontinued because no chance for profit(b) activity sold or discontinued for any reason.

(9) Success of taxpayer in other activities:(a) extent of experience in similar successful business(b) history of losses in a similar activity.

(10) Expected appreciation of asset value:(a) taxpayer expected property to appreciate in value as the major source of investment return.

Sources: Jane O. Burns and S. Michael Groomer, “An Analysis of Tax Court Decisions That Assess the Profit Motive of Farming-Oriented Operations,” The Journal of the American Taxation Association, Fall 1983, pp. 23-39.

Jack Robison, “Tax Court Classification of Activities Not Engaged in for Profit: Some Empirical Evidence,” The Journal of the American Taxation Association, Fall 1983, pp. 7-22.

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Solutions to Chapter 4 Assignment Problems

Problem 3[ITA: 12(1); 18(1); 20(1); IT-442R]TalkTech Inc. is a manufacturer and wholesaler of cellular communication products. TalkTech Inc.’s

customers are retailers who promote TalkTech Inc.’s products to the general public. TalkTech Inc. has an October 31 year-end. You are conducting a review of TalkTech Inc.’s year-end accounting records for its 2006 fiscal year and have been provided with the following information.

TalkTech Inc. has the following recorded reserves:Account Opening Additions Subtractions Closing

Warranty reserve $35,000 $10,000 $17,500 $27,500Allowance for doubtful accounts

32,000 7,500 5,000 34,500

TalkTech Inc. provides a 1-year warranty on most of its products. The warranty is for defects in workmanship or component parts. This warranty is provided as part of the purchase price of TalkTech Inc.’s products. TalkTech Inc. honours its own warranties. The 2006 addition of $10,000 represents a standard percentage of sales made in the 2006 fiscal period. The 2006 subtraction of $17,500 represents an amount actually paid to honour warranties.

The addition of $7,500 to the allowance for doubtful accounts is a result of the application of TalkTech Inc.’s annual year-end aging analysis. In conversation with the controller of TalkTech Inc. you determine that this $7,500 increase in the allowance for doubtful accounts was computed by applying the company’s historical collection percentages to the aged accounts receivable balances. Also, during its 2006 fiscal period, TalkTech Inc. wrote off $5,000 (the subtraction noted above) of amounts previously expensed and included in the opening allowance for doubtful accounts. TalkTech Inc. also ended up collecting $1,500 of previously written-off bad debts.

In an attempt to attract a particular retail customer, TalkTech Inc. provided this new customer with an incentive to make a large initial purchase of its products. On April 1, 2006, TalkTech Inc. sold $300,000 worth of cellular phones to CellBlock Limited. TalkTech agreed to the following payment terms in an attempt to entice CellBlock Limited to make the purchase:

• $100,000 due and payable May 1, 2006; and• $50,000 due and payable January 1 each year starting January 1, 2007 through January 1, 2010.The cost of the good sold under this contract was $180,000. The delivery date for the cellular phones sold

under this contract was May 1, 2006.One of TalkTech’s customers was experiencing financial trouble. As a result, TalkTech Inc. had agreed to

make shipments only if payments were received well in advance of the anticipated shipping dates. Under the terms of this agreement, TalkTech Inc. received $40,000 from Phones’N’Things on September 30, 2006. This payment was an advance payment for a shipment of new technology cellular phones which TalkTech Inc. expected to be shipping to customers commencing February 1, 2007. In the event that TalkTech Inc. was unable to honour its contract with Phones’N’Things, a full refund of the $40,000 was payable.—REQUIRED

(A) Prepare a schedule showing the effect of the above information on income for tax purposes of TalkTech Inc. for the year ended October 31, 2006. From this comparison, determine any adjustments that would be necessary to reconcile accounting income and income for tax purposes for the year.

(B) What would be the tax consequences if the $5,000 subtraction in the allowance for doubtful accounts in 2006 included an account receivable of $800 which was written off only because it has been outstanding for more than 180 days. In fact, it has been outstanding for one year and is part of the opening allowance of $32,000. This $800 could still be collected and there has been no serious attempt to collect it. In fact, the remainder of that customer’s account is current and further sales have been made to that customer.

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Introduction to Federal Income Taxation in Canada

Solution 3Part A

In order to fully understand the income tax implications and thus the resulting adjustments that are needed in computing income for tax purposes, the underlying accounting for the given transactions needs to be discussed. The following solution will address the net impact on the income statement for accounting purposes of each of the transactions and will then compare this to the required income tax treatment of each item. The comparison of the accounting and tax treatment will indicate any necessary adjustments. The major discussion of the tax treatment of each item is found in the notes.

Net impact on income statement

Net impact as per Income Tax

Act

Difference (resulting in T2 Schedule 1

Adjustment)

Warranty reserve(1) $(10,000) $(17,500) $ (7,500)

Accounts receivable(2) (6,000) (6,000) Nil

TalkTech Inc.(3) 120,000 40,000 (80,000)

Phones’N’Things(4) 0 0 0

Notes(1) For accounting purposes, the increase of $10,000 in the balance sheet warranty reserve (a liability account)

will be recorded on the income statement as a warranty expense for the year. The $17,500 subtraction from the balance sheet warranty reserve will simply reduce the cash balance as it represents the actual outlays during the year to honour warranties that were recorded in the current or previous year(s).For tax purposes, the $10,000 increase in the warranty reserve is not an allowable deduction because it represents a contingent amount (not an amount which is paid or payable) which is specifically denied per paragraph 18(1)(e). The amount does not qualify for deduction under paragraph 20(1)(m.l) since it is not an agreement for an extended warranty nor is it insured by a third party insurer. For tax purposes, the $17,500 paid during the year to honour warranty claims is fully deductible because it represents a cost of doing business under paragraph 18(1)(a).

(2) The bad debt expense for the year will be reflected as a single amount on the income statement. However, this expense can often be made up of a number of additions and/or subtractions to this account. The income tax analysis of the bad debt expense on the income statement requires that each individual component of this amount be justified in terms of the relevant provision of the Income Tax Act. For example,— the addition to the allowance for doubtful accounts (and corresponding addition to the bad debt

expense) must meet the requirements set out in paragraph 20(1)(l),— the write-off of bad debts must meet the requirements of paragraph 20(1)(p), and— the recovery of previously written off bad debts is included in income under paragraph 12(1)(l). The

final net amount for both accounting and tax purposes should be the same.TalkTech Inc.’s $7,500 addition to the allowance as a result of the year-end aging is recorded as a bad debt expense and thus will be a deduction on the income statement. The $5,000 written off from the allowance during the year will be a balance sheet adjustment only as it represents amounts previously included in the allowance and thus previously deducted for accounting purposes (as bad debt expense in the previous year). The collection of $1,500 of previously written-off bad debts will be a credit adjustment to the bad debt expense for the year. Thus, for the year 2005, the net impact on the income statement is as follows:Expense — Bad debt expense.......................................................................................... $ (7,500)‘‘Contra expense’’ — Collection of previously written-off bad debt............................... 1,500

Net expense for the year................................................................................................... $ (6,000)

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Solutions to Chapter 4 Assignment ProblemsFor tax purposes, the opening balance in the allowance account must be added to income as per paragraph 12(1)(d) and the closing balance in the allowance is deductible as per paragraph 20(1)(l). The $5,000 write-off of bad debts is allowed as per paragraph 20(1)(p) and the $1,500 of recovered write-offs is income under 12(1)(l). Thus, the net impact for tax purposes is as follows:

Add opening balance per 12(1)(d).................................................................................... $ 32,000Subtract closing balance per 20(1)(l)............................................................................... (34,500)Subtract bad debt write-off per 20(1)(p)........................................................................... (5,000)Add bad debt recovery per 12(1)(i).................................................................................. 1,500

Net impact for the year..................................................................................................... $ (6,000)

(3) The sale to TalkTech Inc. will result in $120,000 of net income for accounting purposes ($300,000 of sales and $180,000 of cost of goods sold). There is no accounting for reduced income due to the instalment payment method being used.For tax purposes, the net income for accounting purposes of $120,000 must be included in income due to section 9 but an $80,000 reserve is allowable under paragraph 20(1)(n) to account for the amount not due. Thus, a net profit of only $40,000 is recorded for the year ended October 31, 2006. The paragraph 20(1)(n) reserve for amounts due later is calculated as that portion of the gross profit on the sale that relates to the uncollected proceeds where at least some part of the proceeds are due more than two years after the date of the original sale (April 1, 2006). The taxation year-end of TalkTech Inc. does not play a role in the calculation of this reserve. $80,000 = $200,000/$300,000 ($300,000 – $180,000)

(4) The deposit received from Phones’N’Things is considered deferred revenue for accounting purposes and will be recorded on the balance sheet only (as a liability).For tax purposes, the $40,000 deposit received must be included in income per paragraph 12(1)(a), although none of that amount has been earned since it is potentially refundable if the shipment of the product does not take place. However, an offsetting reserve of $40,000 is available under paragraph 20(1)(m) because none of the goods are going to be delivered until after the end of the taxation year. Thus, the net impact on income for tax purposes is NIL for the year ended October 31, 2006. The reserve recognizes the fact that none of the amount received and included in income has been earned. This process requires all amounts received to be accounted for in income and that the full amount deducted as a reserve be justified as unearned.

Part BThe $800 amount would not be part of the amount deductible per 20(1)(p) as there is still some hope of

collecting it. Therefore, the deductible amount under paragraph 20(1)(p) for the year will be $5,000 – $800 = $4,200. However, the method described in IT-442R, paragraph 24 would suggest that a reserve for 100% of debts outstanding more than 180 days is reasonable. Thus, a closing reserve that includes this amount could be claimed per paragraph 20(1)(l). Thus, the closing reserve for fiscal 2006 could be increased by $800 to $35,300.

The net impact on income for tax purposes for fiscal 2006 would be the same.Add opening balance per 12(1)(d)................................................................................ $ 32,000Subtract amended closing balance per 20(1)(l)............................................................ (35,300)Subtract amended bad debt write-off per 20(1)(p)....................................................... (4,200)Add bad debt recovery per 12(1)(i).............................................................................. 1,500

Net impact for the year................................................................................................. $ (6,000)

However, in 2007, the $800 will have to be added to income per paragraph 12(1)(d) as it is part of the 2006 year-end allowance. This is a different result than in Part (A) because as a bad debt written-off in fiscal 2006, the $800 would not otherwise be taken into 2007 income unless it was recovered in 2007.

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Introduction to Federal Income Taxation in Canada

Problem 4[ITA: 18; 19; 20(1); 147.2(1)]You have been assigned to the audit team for B.B. JAMS Ltd., one of your significant clients. Below is the

income statement prepared by the company’s accountant for the December 31, 2006 year-end.B.B. JAMS LIMITED

INCOME STATEMENTFOR THE YEAR ENDED DECEMBER 31, 2006

Sales............................................................................... $ 147,840,000Cost of sales (Note (1))................................................. (119,859,000)

Gross profit.................................................................... $ 27,981,000General and administrative expenses (Notes (2)–(7)).... (12,374,000)Selling expenses (Note (8))............................................ (9,311,000)

Income from operations................................................. $ 6,296,000Other income (Notes (9)–(10))...................................... 16,000

Net income before income taxes.................................. $ 6,312,000Provision for income taxes............................................. (2,528,000)

Net income.................................................................... $ 3,784,000

Through various discussions with the accountant, you have been able to determine that the following information has been recorded in the financial statements:

(1) JAMS had a number of items of inventory that did not sell well in the current year. For accounting purposes, the accountant has recorded a reserve for inventory obsolescence. The reserve was calculated based on the carrying value of any inventory item that had not had a sale in the last 180 days. The reserve at year-end was $1,285,000.

(2) JAMS provides insurance for employees and paid the following amounts to Nat Insurance Company during the year:

$2,000,000 insurance policy on the life of the president included in insurance expense ($300 per month)................................................ $ 3,600

$1,000,000 insurance policy on the life of the vice-president — marketing included in insurance expense................................................................... 2,000

Group term life insurance for employees included in salaries and benefits ($37,000 12 months)........... 444,000

Total $ 449,600

JAMS is the beneficiary of the policies on the president and vice-president. On June 1, 2006, JAMS renegotiated its bank debt, and due to the ever increasing responsibilities of the president, the bank required the insurance policy on the life of the president as part of the collateral for the loan. The premiums on the policy are equal to the net cost of pure insurance for the policy.

(3) An analysis of the professional fees for 2006 revealed the following expenses:Legal and accounting fees related to the issuance of shares $ 29,300Legal fees related to amending the articles of

incorporation................................................................ 2,300Costs incurred regarding the renegotiating of the bank

loans............................................................................. 46,100Costs incurred to defend the company against a wrongful

dismissal charge........................................................... 59,600Costs related to the structuring of an agreement for the

purchase of equipment from a foreign company.......... 38,700Appraisal costs to determine value of the equipment for

the bank........................................................................ 5,100

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Solutions to Chapter 4 Assignment Problems(4) During the year, there were substantial repairs completed to the outside of the building. After the

repairs some of the landscaping had to be redone. The total costs were $139,000. Of this, $23,500 relates to the landscaping costs. The entire $139,000 was included in general and administrative expenses.

(5) A review of the other expense accounts included in general and administrative expenses showed the following:

Depreciation and amortization......................................... $ 4,560,000Interest on late payment of municipal taxes.................... 900Severance payments to four managers*........................... 245,000Loss from theft by accounting clerk................................ 4,500Donations to various registered charities......................... 57,000

* All of the amounts were paid in the year.(6) The salaries and benefits account shows contributions for certain employees to the company’s

registered pension plan. The contributions were not actually made until March 31, 2007. The pension plan is a defined contribution (money purchase) plan. The company matches the employees’ contributions on a dollar for dollar basis.

Registered pension plan

Employment compensation

President........................................ $ 12,750 $ 250,000Vice-president................................ 9,750 150,000Accountant..................................... 5,400 70,000

(7) In early November 2006, JAMS announced an early retirement package that was made available to employees over the age of 60. In order to provide employees with the time required to assess the offer, the deadline for accepting the package has been set at February 15, 2007. While no formal replies were received as of December 31, 2006, the personnel manager anticipates a high acceptance rate. She expects that the costs associated with the packages will be $672,000. This cost has been accrued in the 2006 financial statements.

(8) The following information was taken from the various selling expense accounts:Cost of sponsoring presentations at a local theatre

company................................................................... $ 15,000Hockey game tickets given to customers..................... 8,000Meals and entertainment costs of salespeople............. 109,500Staff Christmas party and summer barbecue............... 43,800Cost of sponsoring local little league teams................. 5,000Memberships for salespeople at local golf courses...... 12,700

(9) The other income includes a loss on the sale of various fixed assets of $35,900.(10) During the year, the company had cash on hand for a short period of time due to the timing of certain

contract payments. The funds earned interest income of $10,400 while they were held.Other Information:

(11) The accountant has calculated that JAMS is entitled to claim capital cost allowance and CECA of $5,835,000 in 2006. You have confirmed that this calculation is correct.

(12) In reviewing the income tax assessments, you noted that JAMS had been charged interest of $4,900 on the late payment of instalments. You discussed this with the accountant and determined that the interest was recorded in the income tax expense account.—REQUIRED

Based on the information that you have obtained, calculate the business income for JAMS for December 31, 2006. Show all calculations whether or not they seem relevant to the final answer. Comment on all items omitted from the calculation.

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Introduction to Federal Income Taxation in Canada

Solution 4Note to instructors: Reference to Schedule 1 of the T2 corporate tax return may be helpful in completing

reconciliation problems.Net income per financial statements.................................................................. $ 3,784,000 Sec. 9Add:

Provision for income taxes................................................. $ 2,528,000 Par. 18(1)(e)Charitable donations........................................................... 57,000 Par. 18(1)(a)Over contributions to company pension plan(1)................... 7,000 Ssec. 147.2(1)Loss on disposable of depreciable assets............................ 35,900 Par. 18(1)(b)Depreciation and amortization............................................ 4,560,000 Par. 18(1)(b)Club dues............................................................................ 12,700 Par. 18(1)(l)Meals and entertainment ($109,500 50%)...................... 54,750 Sec. 67.1Hockey tickets ($8,000 50%)......................................... 4,000 Sec. 67.1Non-deductible life insurance — Vice-president............... 2,000 Par. 18(1)(a)

— President ($300 5 months)......................... 1,500 Par. 18(1)(a)

Legal and accounting expenses re issuance of shares (80% $29,300)......................................................... 23,440

Par. 20(1)(e)

Legal expenses re articles of incorporation......................... 2,300 Par. 18(1)(b)Costs re bank loan (80% $46,100).................................. 36,880 Par. 20(1)(e)Costs re equipment purchase.............................................. 38,700 Par. 18(1)(b)Appraisal cost for bank (80% $5,100)............................ 4,080 Par. 20(1)(e)Accrued early retirement payments(2).................................. 672,000 Par. 18(1)(e)Total additions.................................................................... 8,040,250

Subtotal....................................................................... $11,824,250Deduct:

Capital cost allowance........................................................ $ 5,835,000 Par. 18(1)(b)Income from business................................................................ $ 5,989,250

Items not Included in Computation:1. The reserve for inventory obsolescence, although called a “reserve,” is deductible since the amount is

determined by identifying specific items that are obsolete and, therefore, is not a reserve or contingent liability [par. 18(1)(e)].

2. Group term life insurance is deductible as part of the remuneration provided to employees and meets the “incurred to earn income test” in par. 18(1)(a).

3. The life insurance premiums on the president are deductible after June 1, 2006 since the insurance was held as collateral by the bank [par. 20(1)(e.2)].

4. The costs related to the wrongful dismissal charge are deductible as a cost of doing business [par.  18(1)(a)].

5. The repairs to the outside of the building are deductible as a cost of doing business as long as they are not enhancing the value of the building [pars. 18(1)(a), (b)] and the costs of landscaping are specifically allowed [par. 20(1)(aa))].

6. The interest on the municipal taxes is a cost of doing business [par. 18(1)(a)].7. The severance payments are deductible as a cost of doing business [par. 18(1)(a)].8. Theft by an employee is an inherent risk for most businesses and as such the theft usually is a

deductible business expense [IT-185R par. 2 and Cassidy’s Limited v. M.N.R., 89 DTC 686 (T.C.C.)].9. Sponsoring of the local theatre company and sponsoring of the little league teams are deductible as a

cost of doing business [par. 18(1)(a)] as long as they are reasonable in the circumstances. [See No. 577 v. M.N.R., 58 DTC 307 (T.A.B.), and No. 601 v. M.N.R., 55 DTC 128 (T.A.B.).]

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Solutions to Chapter 4 Assignment Problems10. The costs of the staff Christmas party and summer barbeque is exempt from the 50% limitation for

meals and entertainment [par. 67.1 (2)(e)], to the extent that these occasional events do not exceed six times in a year.

11. The interest earned on the cash on hand is considered business income if the income is incidental to the business. The funds were only held for a short time and related to payments on contracts [sec. 9].

12. The interest and penalties on the income tax instalments is not a deductible expense [par.  18(1)(t)]. However, the expense has been recorded as part of income tax expense. Therefore, it has already been added back to income as part of the income tax expense addback. No further adjustment is required.—NOTES TO SOLUTION

(1) RPP [par. 20(1)(q) and ssec. 147.2(1)]President Vice-President Accountant

Least of:(a) Employer plus employee RPP contributions.................... $ 25,500 $ 19,500 $ 10,800(b) Money-purchase limit for 2006........................................ 19,000 19,000 19,000(c) 18% of compensation....................................................... 45,000 27,000 12,600Least amount......................................................................... 19,000 19,000 10,800

Less: employee and employer contributions................................. 25,500 19,500 10,800Amount to be added back (excess of actual over deductible) 6,500 500 Nil

(2) Generally accepted accounting principles require the accrual of the expected payments under the early retirement package if the probability of the payment is likely and the amount can reasonably be estimated [CICA Handbook Section 3290]. A reserve for a contingent liability is disallowed for tax purposes [par. 18(1)(e)]. The deduction will be allowed for tax purposes when there is a legal obligation to pay the amount under the package.

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Introduction to Federal Income Taxation in Canada

Problem 5[ITA: Subdivisions a and b]Coco Hardy is an apprentice with Sepp, a design house in Toronto. In her spare time, during some evenings

and on weekends, she operates a sewing service for clothing manufacturers. She has set aside a spare room in her apartment where she keeps her equipment and materials and performs her services. This room occupies approximately 20% of her apartment. She sews for many of the same companies that deal with her employer, Sepp. The demands of her employment with Sepp will continue to prohibit her from expanding her sewing services. Consequently, she has not advertised for additional sewing work. Her sewing billings average approximately $600 per month.

She and the manufacturers mutually agree upon what type of sewing is to be done in order to meet the manufacturers’ production deadlines. Her hourly rates are determined by the type of sewing required for a particular manufacturer. At the end of each month, she will issue a bill to the manufacturers bearing her name, home address, and home telephone number. Her clients pay her the gross amount on the invoice which does not include GST.

Ms. Hardy has incurred some direct sewing expenses and has allocated some of her other costs to her sewing services in respect of the past year as follows:

Direct expenses:Sewing supplies............................................................................................ $ 2,890Meals and entertainment for manufacturers.................................................. 500Sewing machine repairs................................................................................ 425Long distance telephone calls to manufacturers........................................... 710Delivery of finished product......................................................................... 1,500 Total direct expenses.................................................................................... $ 6,025 Allocated costs:

Rent ($1,000 per month)...................................................... $12,000Utilities................................................................................ 2,100Insurance............................................................................. 400

$14,500Allocation to sewing room...................................................

20%$ 2,900

Capital cost allowance:Sewing room furniture................................................. $ 450Sewing machine........................................................... 325Automobile for deliveries............................................ 1,200 $ 1,975

Total allocated costs..................................................................................... $ 4,875 Total.............................................................................................................. $ 10,900

—REQUIRED(A) Discuss the issues involved in determining whether Ms. Hardy is earning employment income or

business income from her sewing service and then reach a conclusion based on the facts.(B) Compute both income from employment and business, and comment on whether the listed expenses

and allocated costs are deductible for income tax purposes under each alternative.

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Solutions to Chapter 4 Assignment Problems

Solution 5(A)

Coco Hardy’s sewing service would appear to generate business income and not employment income. The characteristics noted below would suggest that she is not an employee.The Economic Reality and Entrepreneur Test(a) The Control Test

The facts suggest that Ms. Hardy is engaged to achieve a prescribed objective and is given all the freedom she requires to attain the desired result.

The fact that she may perform the same services as an apprentice with her employer, does not mean that the services performed on her own time cannot be independent.(b) Ownership of Tools/Risk Tests

Ms. Hardy owns her own tools such as the sewing machine and provides the work space. She takes at least some financial risk in doing the sewing by incurring the direct costs.The Integration or Organization Test

The relationships between Ms. Hardy’s sewing service and the various clothing manufacturers are relationships of mutual dependency. The organization test is properly viewed from the perspective of the individual performing the service. From the perspective of Ms. Hardy, it is her business and not that of the clothing manufacturers. She issues billings in her own name instead of being part of the payroll or benefits programs of the clothing manufacturers. She performs the work on her own time instead of having fixed hours determined for her. She is free to work for others and has many customers. She can decide what is required and how to do the work.The Specific Result Test

Ms. Hardy has agreed to perform a specific task for each particular clothing manufacturer instead of agreeing to be at their disposal on an ongoing basis.(B)

Income from business for one year, assuming a reasonable expectation of profit:

Billings ($600 per month 12)................................................................................................. $ 7,200Direct expenses [$6,025 - (50% of $500)]................................................................................. (5,775)Allocated costs (excluding home office)................................................................................... (1,975) Loss from business before home office costs............................................................................ $ (550)

The CRA’s IT-514, paragraph 4 implies that a deduction for capital cost allowance on office furniture is not limited by subsection 18(12).

Home office expenses from this year (allocated costs other than capital cost allowance) are, in effect, available for indefinite carryforward:

Rent ($1,000 per month)......................................................................................... $ 12,000Utilities................................................................................................................... 2,100Insurance................................................................................................................. 400

$ 14,500Allocation to sewing room...................................................................................... 20% $ 2,900

Comments:(1) All of the expenses listed (with the exception of 50% of the meal and entertainment expenses) should be

deductible on the basis that they were incurred to earn business income as long as an argument can be made that Ms. Hardy has a reasonable expectation of profit.

— While an expenditure need not actually result in income in a particular instance, there must be a reasonable expectation that the business will be profitable within a reasonable time.

— Ms. Hardy is presently operating at capacity and has no business plan to show how increased billings could be achieved. Without a plan to increase her work volume or her hourly rate, she must be expecting to continue incurring a loss for the foreseeable future. Ms. Hardy does not appear to have a

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Introduction to Federal Income Taxation in Canadareasonable expectation of profit. Thus, her excess expenses and allocated costs are not deductible for income tax purposes.

— Consequently, the excess expenses and allocated costs will be considered to be personal or living expenses as defined in subsection 248(1). Paragraph 18(1)(h) will deny a deduction for such amounts.— However, the capital cost allowance of $1,975 may be deductible even if it creates a business loss. The

preamble to subsection 20(1) includes the phrase “notwithstanding paragraphs 18(1)(a), (b) and (h) ...”This may indicate that a deduction for capital cost allowance in subsection 20(1) overrides the limitation in

paragraph 18(1)(h).(2) Home office expenses, as part of the determination of income from business, must also meet the

conditions set out in subsection 18(12). Had there been a reasonable expectation of profit, the home office expenses should have been deductible [spar. 18(12)(a)(i)] as the home office is Ms. Hardy’s principal place of business, but would have been required to be carried forward as they would have increased a loss. Based on the wording in paragraph 18(12)(c), the $2,900 of home office expenses should have been available for indefinite carryforward.

(3) It was determined in this problem that Ms. Hardy was earning business income. However, had she incurred the same expenses and allocated costs as part of her employment and had been required by the terms of her employment to maintain an office in her home, the impact on employment income would have been as follows:

Employment income ($600 12)............................................................................................... $ 7,200Deductions:

Sewing supplies [spar. 8(1)(i)(iii)]..................................................................... $ 2,890Delivery [pars. 8(1)(h), (h.1)]............................................................................ 1,500Automobile (CCA) [par. 8(1)(j)]....................................................................... 1,200 5,590

Income before home office expenses $ 1,610Less: home office expenses per ssec. 18(13):

Rent [spar. 8(1)(i)(ii)]........................................................................................ $ 12,000Utilities [spar. 8(1)(i)(iii), IT-352R2]................................................................ 2,100Insurance [IT-352R2, par. 6]............................................................................. Nil

$ 14,100 Allocation to sewing room........................................................................................ 20% 2,820 Employment income.................................................................................................................... Nil

The excess home office expenses of $1,210 (i.e., $2,820 - $1,610) would be available for carryforward [par. 8(13)(c)].

Presumably, the employer would reimburse the employee for other costs such as the meals and entertainment of $500, the long distance telephone calls to manufacturers of $710, and the sewing machine repairs of $425.

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Solutions to Chapter 4 Assignment Problems

Problem 6[ITA: 8(1)(f), (h), (h.1), (i), (j), (3); 18-20]Mr. Peter Rajagopal, who is a salesman in Regina, Saskatchewan, has incurred the following expenses in

connection with his employment in 2006. He was not reimbursed and did not receive an allowance in respect of any of these expenses. Peter has a form T2200, signed by his employer, attesting to all of these expenses.

(1) Peter uses one room in his home exclusively as a home office. He uses his home office most days and evenings to do paperwork and make phone calls and his home office computer is connected to his employer’s computer system by modem. He visits his office at his employer’s premises approximately once a week and spends the remainder of the time on the road, making sales calls throughout Western Canada.

(2) The following expenses relate to Peter’s home office which occupies 10% of the square footage of his house:

Utilities............................................................................ $ 3,100Mortgage interest............................................................. 12,000House insurance............................................................... 1,150Municipal taxes................................................................ 3,050Maintenance and repairs.................................................. 2,700

Total......................................................................... $ 22,000

10% thereof.............................................................. $2,200Capital cost allowance on computer equipment ($6,900

15%)..................................................................... 1,035Rental of photocopier...................................................... 1,200Rental of fax machine...................................................... 200Office supplies................................................................. 750Additional monthly charges for telephone services for family internet connection (12 $30)............................. 360Long distance calls.......................................................... 1,000

(3) Peter also has the following promotional expenses:Meals (with clients in Regina, excluding the cost of his

own meals)...............................................................$ 2,100

Theatre tickets.................................................................. 1,200Promotional gifts.............................................................. 1,300Country club membership................................................ 3,200

(4) Peter paid the following automobile expenses:Gas & oil......................................................................... $ 2,000Insurance......................................................................... 1,100Licence............................................................................ 90Repairs............................................................................. 800Cellular phone airtime charges (used for employment-

related calls only)..................................................... 700Parking (employment related)......................................... 320

Peter purchased the car that he uses for employment purposes on May 1, 2005 for $50,000 plus $3,500 GST and $5,000 provincial sales tax. Peter did not claim CCA on the car in 2005; therefore, the capital cost allowance rate for the car is 30% in 2006. The car was driven a total of 40,000 km in 2006; 32,000 of the kilometres driven related to Peter’s employment use.

(5) Peter also incurred the following travel expenses (while away at least 12 hours):Airfare............................................................................. $ 4,520Meals and accommodation (including $2,400 for meals) 4,960Registration fees for convention in Vancouver to

increase product knowledge .................................... 800

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Introduction to Federal Income Taxation in CanadaOut-of-town entertainment.............................................. 3,200

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Solutions to Chapter 4 Assignment Problems(6) Interest on bank loan:

— to buy the computer equipment for the home office in (1) above $ 320

— to buy the car in (4) above 800(7) Peter’s remuneration from employment is as follows:

Salary............................................................................... $ 40,000Bonus based on company sales........................................ 17,000

—REQUIREDCompute the total deductible amount of expense under each of the following sets of assumptions:(A) Peter chooses to use the following deductions as an employee:(i) paragraphs 8(1)(h), (h.1), (l), and (j), or(ii) paragraphs 8(1)(f), (i) and (j).(B) Peter’s situation is changed to that of an independent sole proprietor.Assume that all the amounts given are accurate, supported by receipts and reasonable in the circumstances.

Present your answer in tabular form for ease of comparison of alternatives.

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Introduction to Federal Income Taxation in Canada

Solution 6Notes on restriction of deductions as an employee:

— Total deductible home office expenses cannot be used to create a loss from employment income [ssec. 8(13)]. However, any excess can be carried forward against employment income, in effect, indefinitely. This loss limitation rule will not have an effect in this particular case since total deductible expenses do not exceed remuneration. However, one of the following conditions must be met:(a) the home office must be the place where the individual principally performs the duties of the office

or employment, or(b) the home office was used exclusively and on a regular and continuous basis for meeting customers

in the ordinary course of performing the duties.Since Peter uses one room in his home exclusively as a home office, uses the office most days and

evenings, and visits his office at work only once a week, spending the rest of the time on the road, it appears that condition (a) is met because his home office is the place where he “principally” performs the duties of the office or employment. This assumes that his duties are considered to be performed principally from his home office and not principally from either his office at work or on the road. If it can be argued, based on the facts of the situation, that his duties are performed principally on the road, then neither condition (a) nor (b) is met and no home office expenses are allowed.

— Mortgage interest, capital cost allowance on computer and interest on loan to purchase computer are outlays on account of capital which are not deductible in computing employment income [spar. 8(1)(f)(v)]. Subparagraph 8(1)(f)(v) does not permit the deduction of outlays of a capital nature except as described in paragraph 8(1)(j). The only amounts permitted under paragraph 8(1)(j) which are applicable, in this case, are capital cost allowance and interest on a car.

— Utilities and maintenance and repairs all qualify as supplies under paragraph 8(1)(i), but house insurance and municipal taxes do not [IT-352R2, paragraph 5].

— House insurance, municipal taxes, and the rental of the photocopies and fax machine are only deductible under paragraph 8(1)(f).

— Long distance telephone calls are deductible under subparagraph 8(1)(i)(iii) as supplies [IT-352R2, par. 9(d)].

— The monthly charge for the family internet connection is not deductible because it is a personal expense. A separate phone line would be deductible under paragraph 8(1)(f).

— Section 67.1 restricts the deduction for all meals and entertainment to 50% of the amount incurred. This applies to the theatre tickets and all meals related to travelling and to entertaining clients.

— Meals and entertainment (limited to 50%) and promotional gifts ($1,300) are deductible under paragraph 8(1)(f) only. However, subsection 8(4) denies the deduction for meals unless the employee incurs these expenses while performing his/her employment duties, for a period of not less than 12 hours, away from the municipality where his/her employer’s establishment is located and where he/she ordinarily reports for work.

— The country club membership ($3,200) is not deductible because paragraph 8(1)(f) does not allow the deduction of expenses referred to in paragraph 18(1)(l).

— Travelling expenses re car: because only 32,000km out of the 40,000 km driven are employment-related, only 80% of the car expenses are deductible with the exception of the cellular phone airtime and parking expenditures which are 100% employment-related. These amounts are deductible under paragraph 8(1)(h.1) or 8(1)(f), except for the cellular phone airtime which is deductible under subparagraph 8(1)(i)(iii) as supplies per IT-352R2, paragraph 9(d).

— The maximum CCA claim is restricted to the CCA on $30,000 (2005 acquisition) plus GST (7%) and PST (10%). 80% of the CCA claim is deductible [spar. 8(1)(j)(ii)].

— All of the travelling expenses are deductible under paragraph 8(1)(f), subject to the section 67.1 restriction of 50% for meals and entertainment. However, the deduction under paragraph 8(1)(h) excludes the out-of-town entertainment.

— Deductible expenses under paragraph 8(1)(f) total $18,162 but the maximum amount deductible thereunder is limited to the $17,000 bonus based on sales. Note that Peter may still deduct amounts under paragraphs 8(1)(i) (in respect of supplies) and 8(1)(j) (in respect of capital cost allowance and interest) outside of this limit [IT-352R2, paras. 5 and 9]. His total claim is therefore $29,094.

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Solutions to Chapter 4 Assignment Problems— The alternative is to deduct travel expenses under paragraph 8(1)(h) and car expenses under paragraph

8(1)(h.1) which are not limited to his $17,000 bonus based on sales rather than a deduction under paragraph 8(1)(f). Capital cost allowance under paragraph 8(1)(j) and expenses under paragraph 8(1)(i) would be claimed as well. Since his total claim under this alternative is $23,886, Peter is better off making a claim under paragraphs 8(1)(f), (i) and (j).

Notes on restriction of deductions as a proprietor:— The home office restrictions in subsection 18(12) are very similar to the rules in subsection 8(13).

Home office expenses cannot be used to create a loss but any excess can be carried forward, in effect, indefinitely. Subsection 18(12) only allows the deduction of home office expenses in the computation of business income if one of the conditions in subparagraphs 18(12)(a)(i) or (ii) are met. These conditions are very similar to the conditions in subparagraph 8(13)(a)(i) and (ii) as outlined above for an employee.

— The home office expenses are not restricted to deductions in section 8 — therefore the mortgage interest, the CCA on the computer and the interest on the computer loan are allowed. Peter could deduct capital cost allowance on office portion of the house (the amount is not given in the question), but it is not advisable since it would disqualify that portion of the house from a principal residence exemption. (See Chapter 7.)

— Subsection 20(10) allows a deduction for up to two conventions in locations which are consistent with the territorial scope of a business.

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Introduction to Federal Income Taxation in CanadaCOMPARISON OF DEDUCTIONS

for Mr. Peter RajagopalOrdinary employee

[s. 8(1)(h), (h.1), (i), (j) ]

Salesperson/Negotiators

[ s. 8(1)(f) ] [ s. 8(1)(i), (j) ] ProprietorHome office:

Utilities (10% $3,100).................................$ 310(1) — $ 310 $ 310Mortgage interest(2) (10% $12,000)............. — — — 1,200House insurance(2) (10% $1,150)................ — $ 115 — 115Municipal taxes(2) (10% $3,050)................. — 305 — 305Maint. and repairs (10% $2,700)................ 270 — 270 270CCA on computer ($6,900 15%)................ — — — 1,035Rental of photocopier...................................... — 1,200 — 1,200Rental of fax machine..................................... — 200 — 200Office supplies................................................ 750 — 750 750Interest on computer loan................................ — — — 320

Telephone:Internet............................................................ — — — —Long distance calls.......................................... 1,000 — 1,000 1,000

Promotional expenses:Meals (with clients) (50% $2,100).............. — 1,050 — 1,050Theatre (50% $1,200)................................. — 600 — 600Promotional gifts............................................. — 1,300 — 1,300Country club membership............................... — — — —

Automobile expenses:Gas & oil (.8 $2,000).................................. 1,600 1,600 — 1,600Insurance (.8 $1,100).................................. 880 880 — 880Licence (.8 $90).......................................... 72 72 — 72Repairs (.8 $800)......................................... 640 640 — 640Cellular phone airtime..................................... 700 — 700 700Parking............................................................ 320 320 — 320CCA on car(3)................................................... 8,424 — 8,424 7,920Interest on loan (.8 $800) [under limit of $300/mo.].................................................... 640 — 640 640

Other travel expenses:Airfare............................................................. 4,520 4,520 — 4,520Accommodation ($4,560 – $2,000)................. 2,560 2,560 — 2,560Meals (50% $2,400).................................... 1,200 1,200 — 1,200Convention (excl. meals)................................ — — — 800(4)

Meals and entertainment ($3,200 50%)...... — 1,600 — 1,600 Total.......................................................................$ 23,886 $ 18,162 $ 12,094 $ 33,107Limit....................................................................... none 17,000 none none Deduction(5).............................................................$ 23,886 $29,094 $ 33,107

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Solutions to Chapter 4 Assignment Problems—NOTES TO SOLUTION

(1) Deductible [spar. 8(1)(l)(iii)], as explained in IT-352R2, par. 5.(2) Based on the case of Felton v. M.N.R., 89 DTC 233 (T.C.C.), and concurred with in The Queen v.

Thompson, 89 DTC 5439 (F.C.T.D.), mortgage interest, municipal taxes, and house insurance are not deductible by an employee as office rent under subparagraph 8(1)(i)(ii). (See also IT-352R2, paragraph 6, which indicates that taxes and insurance are deductible under paragraph 8(1)(f)).

(3) For an employee, the CCA would be $8,424 (32k/40k $30,000 1.17 30%). Peter would receive a GST rebate in 2007 for all his deductible expenses except the car CCA and car insurance with an offsetting income inclusion of 6.5/106.5 of the same amount (assuming an average GST rate of 6.5% in 2006, under a May 2, 2006 federal budget proposal that was legislated, effective July 1, 2006). As a sole proprietor and a GST registrant, he would receive an ITC for all his expenses except the CCA and car insurance. The CCA would be $7,920 (32k/40k $30,000 1.10 30%).

Capital cost allowance and interest on car, deductible under paragraph 8(1)( j), and certain office costs and supplies deductible under paragraph 8(1)(i), (IT-352R2, pars. 5 and 9) are not restricted by the amount of commission income. The restriction applies only to amounts deductible under paragraph 8(1)(f).

(4) Note that the provisions in sections 18, 19 and 20 pertain to expenditures including convention expenses deductible from income from business. However, the deduction of such expenditures is far more restricted in subsection 8(1) and, while convention expenses are allowed by subsection 20(10), convention expenses would not be allowed by any of paragraphs 8(1)(f),(h),(h.1), or (i). Note that only 50% of the cost of meals consumed at a convention is deductible, where the cost of meals is known; otherwise 50% of $50 or (i.e., $25) per day is deductible.

(5) Neither of the deduction limits in subsection 8(13) or subsection 18(12) applies in this case, because there will not be an employment or a business loss.

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Introduction to Federal Income Taxation in Canada

Problem 7[ITA: 37; ITR: 2900(2)(3); 2903]Joe’s Widget Manufacturers Inc. (JWMI) is an established manufacturing company with a growing research

and development (R&D) department. JWMI is a Canadian-controlled private corporation with no associated companies. The research part of the business is new and the company’s accountant has no experience dealing with the tax implications of the expenditures in this area. He has correctly computed the company’s net income for tax purposes before specific R&D related adjustments as $615,000 and would like your input on the impact of the transactions described below.

For the year ended December 31, 2006, the following R&D related expenditures were made.Description Amount

Purchase of lab machinery and lab equipment. . . $ 450,000Purchase of building to house laboratory........... 120,000Salaries of lab staff............................................. 100,000Operating costs directly related to the lab........... 40,000

The lab machinery, equipment and building are used 100% for R&D activities. The lab machinery and equipment have been capitalized for accounting purposes and are being amortized over an eight-year period (net of available investment tax credits as set out below). Thus, amortization expense of $36,562 was recorded for accounting purposes on the lab machinery and equipment. Depreciation expense of $4,800 was recorded on the building.

The company is eligible for investment tax credits at a rate of 35% and has correctly determined that they are eligible for investment tax credits at this rate on all of the above expenditures with the exception of the building. No investment tax credit is allowable on the purchase price of the building. For accounting purposes, the company’s accountant has netted the investment tax credits against the related expenditures as follows.

Expenditure Gross amount ITCAmount recorded

for accounting purposes

Lab machinery and equipment......................... $ 450,000 $ 157,500 $ 292,500Building............................ 120,000 0 120,000Salaries of lab staff........... 100,000 35,000 65,000Operating costs of lab....... 40,000 14,000 26,000

—REQUIREDBased on the above information, explain to JWMI’s accountant the adjustments necessary in computing

income for tax purposes for the years ended December 31, 2006 and 2007.

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Solutions to Chapter 4 Assignment Problems

Solution 72006 2007 Reference

Net income for tax purposes before R&D............................... $ 615,000(1) (2)

Add:Amount booked for salaries............................................. 65,000Amount booked for operating costs of lab....................... 26,000Investment tax credits on lab machinery and equipment(2)... 157,500 Pars. 37(1)(e);

& 12(1)(v) same as above

Investment tax credits on salaries(3).................................. 35,000Investment tax credits on operating costs of lab(3)............ 14,000

Deduct:100% of cost of lab machinery and equipment(4)............. (450,000) Par. 37(1)(b)100% of lab salaries......................................................... (100,000) Par. 37(1)(a)100% of lab operating costs............................................. (40,000) Par. 37(1)(a)

Net income for tax purposes.................................................... $ 116,000

—NOTES TO SOLUTION(1) The depreciation and amortization has already been added back in arriving at this number. CCA on the

building would have been deducted.(2) We can only determine the impact of the year 2006 R&D expenditures on the year 2007 income, but we

do not know any further details of the income for tax purposes for the year 2007, as this is yet to be determined.(3) In reality, a pool of R&D expenditures would be created in the year 2006 and include all of the amounts

deducted above. This pool will be reduced to Nil to the extent that all of the year 2006 eligible expenditures on R&D are in fact claimed on the tax return. This pool will increase in 2007 by any R&D expenditures made in that year and eligible for deduction under section 37. The balance in this pool will then be reduced in 2007 by the investment tax credits (in total $206,500, i.e., 35% of ($450,000 + $100,000 + $40,000)) claimed in the preceding year (2006) thus resulting in a smaller pool of available deduction in the year 2007.

(4) The building is not eligible for the 100% write-off due to the restriction in paragraph 37(8)(d).

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Introduction to Federal Income Taxation in Canada

Problem 8[ITA: 9-12; 18-20; 37; 67.1; 78; 147]The unaudited income statement for Lomas & Sons Limited for its year ended December 31, 2006 shows

the following:Sales............................................................ $ 795,000Cost of sales................................................ $ 350,000General and administrative expenses.......... 225,000Research and development expenditures.... 76,700 (651,700)

Operating income........................................ $ 143,300Other income.............................................. 20,000

Net income before taxes.............................. $ 163,300Provision for income taxes:........................

— current............................................. $ 27,000— future............................................... 25,000 (52,000)

Net income after income taxes.................... $ 111,300

The information in the following notes has already been reflected in the above income statement.(1) Payment made by company on April 1, 2007, to a

defined contribution (money-purchase) registered pension plan for the president of the company in respect of current employment service, allocated to 2006 expenses by the company’s accountant; in addition, the president had $7,500 withheld from his compensation of $74,000 for the RPP.......................... $ 7,000

(2) Increase in warranty reserve on company’s product (net of expense incurred; based on self-insurance warranty program)........................................................ 16,000

(3) Depreciation expense recorded in the financial statements..................................................................... 30,000

(4) Landscaping costs re: factory premises...................... 2,500(5) Interest on bank loan obtained for the purpose of

purchasing common shares in Advanco Ltd., a dividend-paying Canadian corporation........................ 6,300

(6) Legal costs of arranging an agreement among shareholders................................................................. 8,500

(7) Legal and accounting fees related to issue of shares.. 12,700(8) Interest on municipal real estate taxes paid late in

error.............................................................................. 1,000(9) Golf club membership fees........................................ 2,200(10) Donation to United Way.......................................... 3,000(11) Meals and entertainment for clients......................... 4,000(12) Appraisal fees to determine selling price of fixed

assets............................................................................ 6,200(13) Premium on term insurance on life of president

with the corporation as beneficiary; policy was not required to be assigned as collateral for corporate borrowing from the bank.............................................. 2,800

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Solutions to Chapter 4 Assignment Problems

(14) Management bonuses ($20,000 of the bonuses expensed in 2006, and shown as ‘‘Bonus Payable’’ on the Balance Sheet as at December 31, 2006 has not been paid at the time of filing the corporate tax return on June 30, 2007)......................................................... 40,000

(15) Amortization of bond discount on bonds issued in 2001............................................................................. 3,400

(16) The company has capitalized and will amortize over five years $90,000 of costs incurred in 2006 related to the purchase of machinery to be used for qualifying research and development. The resultant amortization of the net cost after the investment tax credit was $11,700 and is included in the income statement deduction for research and development expenditures. As well, the company incurred current research and development expenditures of $100,000. These current expenditures will qualify the company for an investment tax credit of $35,000. The $35,000 has been deducted from the expenditure on SR&ED, as shown in the income statement. In the previous year, the company made $95,000 in qualifying SR&ED current expenditures. The company claimed an investment tax credit of $33,250 in respect of these current expenditures.

(17) Interest and penalties on income tax assessments, expensed for accounting purposes................................ 1,250

(18) Items included in the financial accounting statements in arriving at the net profit:Amount paid by an insurance company on its

business interruption insurance to compensate for loss of profits when company was closed down for a month during the year because of a fire................. 26,800

Dividends received....................................................... 1,700Volume rebates and purchase discount........................ 16,000

—REQUIREDBased on the foregoing information, compute the income from business or property for tax purposes,

ignoring tax deductions in respect of depreciable capital or eligible capital property for Lomas and Sons Limited in respect of its 2006 fiscal year. In addition, comment on all items not included in your derivation of income from business or property.

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Introduction to Federal Income Taxation in Canada

Solution 8Note that the financial statements presented in the problem are unaudited and, hence, may not follow GAAP.

Net income after taxes per income statement $ 111,300Add: Provision for income taxes..................................................... $ 52,000 Pars. 18(1)(e), (t)

Payment to registered pension plan in excess of $5,820 (i.e., (18% of $74,000) – $7,500) deductible in 2006 ($7,000 – $5,820)(1)....................................................................... 1,180

Par. 20(1)(q)

Warranty reserve on company’s product(2).............................. 16,000 Par. 18(1)(e)Depreciation expense.............................................................. 30,000 Par. 18(1)(b)Cost of shareholder agreement (an expenditure of a capital

nature pertaining to the sale of shares by shareholders)(3) 8,500 Par. 18(1)(b)

Non-deductible issue expense (4/5 $12,700)(4)...................... 10,160 Par. 20(1)(e)Golf club membership fees...................................................... 2,200 Par. 18(1)(l)Donation to United Way (not deductible from business

income)............................................................................ 3,000 Par. 18(1)(a)

Non-deductible portion of meals and entertainment (50% of $4,000)............................................................................. 2,000 Sec. 67.1

Appraisal fee (an expenditure of a capital nature)................... 6,200 Par. 18(1)(b)Life insurance premium (does not earn income)..................... 2,800 Par. 18(1)(a)Unpaid management bonuses(5)............................................... 20,000 Ssec. 78(4)Amortization of bond discount(6)............................................. 3,400 Par. 18(1)(b)Amortization of SR&ED machinery....................................... 11,700 Par. 18(1)(b)

Investment tax credit for SR&ED (claimed in 2005).............. 33,250 Pars. 37(1)(e), 12(1)(v)

Interest and penalties............................................................... 1,250 203,640 Par. 18(1)(t)Deduct: items not deducted in accounting statements but

deductible for tax purposes:Capital scientific research and development expenditures (not capitalized for tax purposes)........................................................................................................ (90,000) Par. 37(1)(b)

Current SR&ED expenditure ITC (not netted against cost in 2006 for tax purposes)............................................................................................................. (35,000) Net income from business and/or property for tax purposes............................... $ 189,940

Items not included in computation above:— Landscaping costs deductible [par. 20(1)(aa)].— Interest on loan to buy shares deductible [par. 20(1)(c)].— Interest on property taxes deductible as incurred to earn income [par. 18(1)(a)].— Insurance proceeds to compensate for profits included [sec. 9].— Investment tax credit on SR&ED claimed in 2006 to be included in income in 2007.— Dividends received are included in income from property [par. 12(1)(j)].— Volume rebates and purchase discounts reduce the cost of goods sold as a part of normal business

operations.—NOTES TO SOLUTION

(1) The excess contribution would not be in violation of RPP registration requirements, since it was contributed in the first 120 days of 2007 and will likely be deductible in respect of 2007.

(2) Paragraph 20(1)(m.1) permits a manufacturer to deduct prepaid insurance premiums paid to insure against risk under extended warranties sold to customers. The reserve must be in respect of goods to be delivered or services to be rendered under the warranty and cannot exceed the prepaid portion of the premium that was payable to an insurer that carried on an insurance business in Canada. The reserve in this case does not qualify.

(3) The potential subsection 15(1) benefit to the shareholder is not considered in this problem.

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Solutions to Chapter 4 Assignment Problems(4) One-fifth of legal and accounting fees deductible [par. 20(1)(e)].(5) The amount of a bonus unpaid 180 days after the end of the employer’s fiscal period can only be

deducted when it is paid and not when it was incurred.(6) A deduction for a bond discount is available within the limits of paragraph 20(1)(f) only at the earlier of

redemption or maturity of the bonds when the amount is paid. Since no amount is paid, as required by paragraphs 18(1)(f) and 20(1)(f), the amortization is like a reserve which is denied [par. 18(1)(e)] or is considered to be on account of capital and denied [par. 18(1)(b)].

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Introduction to Federal Income Taxation in Canada

Problem 9[ETA: 123(1); 161; 164; 169(1); 170(1)(a); 232; 236; Sched. V, Part VII]Reconsider the facts of Problem 8.

—REQUIRED(A) Outline the general GST requirements applicable in this corporate situation.(B) Indicate the appropriate GST treatment of the items listed in the additional information notes.

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Solutions to Chapter 4 Assignment Problems

Solution 9(A) Since the corporation is carrying on business, it is engaged in a commercial activity. [ETA: ssec. 123(1)]

Therefore, the corporation is required to register and collect GST on its supplies, i.e., sales of goods, which are “taxable supplies.” As a registrant, the corporation is entitled to a full input tax credit (ITC) in respect of GST paid or payable on goods and services that it purchases for use in its commercial activity. [ETA: ssec. 169(1)] If GST collected or collectible on its sales exceeds its ITCs, the corporation must remit the difference. On the other hand, if ITCs exceed GST collected or collectible, a refund of the excess is available.

Since the corporation’s annual revenue is less than $6 million but greater than $500,000, it will be required to file GST returns on a quarterly basis. It may, however, elect to file GST returns on a monthly basis.

The following is the appropriate GST treatment of the items listed in the income statement.• Net income according to financial accounting statements is comprised of revenues and costs (expenses).

GST would have been charged on the revenue items and GST would have been paid on the expenses. GST charged net of ITCs from GST paid or payable must be remitted.

• There are no GST implications for the provision for income taxes.(B) The following is the appropriate GST treatment of the additional information items:

(1) Employer contributions to a registered pension plan involve a payment for an exempt supply on which no GST is charged. [ETA: ssec. 123(1)] As a result, no ITC is available.

(2) A charge to customers for a warranty would be subject to GST which must be remitted by the corporation collecting it. Expenses incurred under the warranty may be subject to GST which will provide the corporation with an ITC. Increasing the reserve, by itself, will have no GST consequences.

(3) GST paid on the purchase of depreciable property provides an ITC, as discussed in Chapter 5. When the cost of the asset is subsequently written off through depreciation or capital cost allowance, there are no further GST implications.

(4) Landscaping costs are incurred for goods and services which are taxable supplies. Hence, GST would be paid in respect of these costs and an ITC would be available.

(5) Interest on a bank loan results from a financial service which is an exempt supply on which no GST is paid. [ETA: Schedule V, Part VII]

(6) The cost of arranging a shareholder agreement may include, for example, legal fees which are subject to GST and which would provide an ITC.

(7) Legal and accounting fees related to the issue of shares would be subject to GST. As the issue of shares is a financial service, an ITC would not normally be available to the corporation. However, relief is available [ETA: sec. 185], since the financial service is related to the commercial activities of the corporation. This provision would allow the payer corporation to claim an ITC.

(8) Interest paid results from a financial service which is an exempt supply on which no GST is paid.(9) Golf membership fees do not give rise to an ITC [ETA: par. 170(1)(a)].(10) Donations involve a transfer of money without consideration. No GST is charged on the donation

and, hence, no ITC is available. [ETA: ssec. 123(1)](11) Initially, an ITC is available on the full amount of GST paid in respect of meals and entertainment.

However, the same fraction used for the disallowed deduction applied to the ITC in respect of such expenditures is recaptured in the first reporting period of the next fiscal year. [ETA: sec. 236]

(12) Appraisal fees are charged for a service which is a taxable supply. Hence, an ITC would be available to the payer corporation.

(13) Insurance premiums are for an exempt supply of a financial service and, hence, no ITC is available, since no GST was paid.

(14) Amounts paid to employees as remuneration are not supplies, since these amounts are excluded from the definition of services in subsection 123(1) of the ETA. As a result, remuneration is not subject to GST.

(15) A bond discount is a cost incurred in respect of a financial service which is an exempt supply. No GST is paid and, hence, no ITC is available.

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Introduction to Federal Income Taxation in Canada(16) As indicated above, GST paid on the purchase of machinery provides an ITC. The capitalization of

the research and development expenses would not have any GST consequences. However, the current research and development expenditures incurred would likely have been subject to GST. As a result, an ITC may be claimed.

(17) Interest and penalties charged by governments are not subject to GST.(18) Items included in financial accounting statements:

(i) Insurance premiums are paid in respect of a financial service which is an exempt supply. An amount received from an insurance company under a policy also involves an exempt supply of a financial service.

(ii) Dividends received involve an exempt supply of a financial service on which no GST is collected.

(iii) Cash discounts reduce the cost of goods on which GST is paid only where the customer is invoiced for the net amount. However, if the invoice is for the full amount and a cash discount is subsequently taken, the cost of goods on which GST is paid is not reduced. Thus, the payer may claim a full ITC. [ETA: sec. 161] Adjustments made to reflect changes in the consideration payable for a supply arising from volume rebates will allow the supplier to refund the excess GST charged, provided a credit note is issued. Thus, the payer’s ITC will be reduced. [ETA: sec. 232]

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