WHAT’S DEDUCTIBLE AND WHEN?
Every business incurs and pays a wide variety of business-related expenses on a day-to-day basis, ranging from employee payroll to advertising costs to utilities bills to the cost of new equipment. The general rule, for tax purposes, is that all reasonable current expenses which are incurred for the purpose of earning business income are deductible from that income. Effectively, a business doesn’t pay income tax on income which has been used to pay expenses related to earning that income.
While the rule regarding the deduction of business expenses can be stated in simple terms there are, within that rule, myriad exceptions, qualifications, and restrictions. Most of those are the result of provisions in our tax law that limit, in one way or another, the amount of deduction which can be taken for a particular kind or class of expenses.
Current vs. capital expenses
The first step to be taken in determining whether a business expense can be deducted from income in the year in which it is incurred is determining whether the expense is “current” or “capital” in nature. Current expenses can, in most cases, be wholly deducted from income earned in the year in which the expense is incurred. A deduction can also be claimed for capital expenses, but those must be deducted over the course of a number of years, through the tax system’s capital cost allowance (CCA) regime. The line between current and capital expenses isn’t always a clear and distinct one, and many disputes (and much tax litigation) have taken place over the years in the determination of which side of that line a particular expense falls. The general rule is that an expense is capital in nature (and therefore cannot be deducted in its entirety from current year income) where it brings into existence an asset of enduring benefit to the taxpayer. In this context, enduring benefit is taken to mean having a useful life of more than one year.
Current expenses —what’s “reasonable”?
Where an expense has been determined, under the CRA guidelines, to be a current expense and therefore deductible in the year it was incurred, the next criterion which will apply is whether the expense was “reasonable”. Reasonableness is, of course, often in the eye of the beholder, and there are undoubtedly many cases in which the CRA has disallowed a deduction for expenses which are, in the taxpayer’s view, reasonable in nature.
A final point—no matter what the kind or amount of costs or expenses claimed, it is up to the taxpayer, in all cases, to both justify the expense (in terms of it having been incurred to earn business income) and to document the cost. While receipts for business expenses claimed do not have to be filed with the annual return, the CRA has the right to ask to see those receipts. And, as with any expense claimed by a taxpayer, where the receipt or other proof of the expense cannot be produced, the CRA must assess on the basis that the expense was not incurred and the deduction will therefore be disallowed. Once it has been determined that an expense is a current expense and the reasonableness standard is met, the next step is to determine whether the expense can be deducted in its entirety, or whether the tax system imposes limitations on either the timing or the amount of the deduction.
What follows is a general listing of business expenses which can be wholly deductible in the year they are incurred, followed by a listing of those to which special (usually limiting) treatment applies.
Examples of expenses wholly deductible in the year:
- Bad debts
- Business tax, fees, licences, dues, memberships, and subscriptions
- Office expenses
- Legal, accounting, and other professional fees. – No deduction is available, however, for legal or other fees paid in connection with the acquisition of a capital property. Instead, those fees are added to the cost of the property and claimed through the capital cost allowance system.
- Property taxes and rent
- Maintenance and repairs
- Salaries, wages, and benefits
- Telephone and utilities
- Delivery, freight, and expenses
Expenses partly deductible in year of expenditure
In some areas, the tax rules impose limitations on the deduction of expenses which would, under the general rules, be wholly deductible in the year in which they are incurred. In some cases, the amount of the deduction is limited or capped because the CRA is seeking to exclude a part of the cost which relates to personal use and enjoyment. In other cases, the tax rules require that part of the deduction be deferred to a later year to which it more properly relates.
- Meals and entertainment (50% Deductible)
- Prepaid expenses – It is sometimes the case that a business will pay for services or goods which are to be provided to it throughout the current year and into the next one. The example used by the CRA in its guide is that of a business which, on June 30, 2012, prepays its rent for a full year (from July 1, 2012 to June 30, 2013). In such circumstances, the rule is that one half of the rent is deductible as an expense on the business’s return for the 2012 taxation year, while the other half is deducted as an expense in 2013.
- Motor vehicle expense (business percentage)
Business use-of-home expenses—a special case
Where part of a home is used for business purposes, some of the expenses related to that home become, in effect, business expenses, and may be deducted from business income. In order to deduct such expenses, it is necessary that the business space in the home be either the principal place of business or that it be used only to earn business income and be used on a regular and ongoing basis to meet clients, customers or patients. Once either of those criteria are satisfied, the business can deduct a portion of heating, home insurance, and electricity costs, as well as a part of property taxes, mortgage interest (but not mortgage principal).
The kinds of expenses incurred by Canadian businesses are as many and as varied as the businesses themselves. The CRA issues a guide to the computation of Business and Professional Income (T4002(E)), which summarizes the tax treatment of all of the types of expenses outlined above, and many more, and that guide is available on the CRA Web site at http://www.cra-arc.gc.ca/E/pub/tg/t4002/t4002-10e.pdf. There is also a portion of the CRA Web site devoted to the tax treatment of business expenses, and that can be found at http://www.cra-arc.gc.ca/tx/bsnss/tpcs/slprtnr/bsnssxpnss/menu-eng.html. If neither of those sources can provide an answer to a particular question, the professionals at White Kennedy LLP would be pleased to help.