Ostensibly, the proposals are meant to clarify how the Act links the deductibility of certain expenses, such as interest, to a taxpayer's prospects for profit. As drafted, the proposed amendments represent a limitation on losses that encompasses virtually all expenses incurred by taxpayers in earning income from a business or property. As explained below, the proposals would effectively create a loss denial rule that would depend on the application of a reasonable expectation of profit test.

The press release accompanying the proposed amendments suggests that the proposed amendments should be read together with the interpretation bulletin on interest deductibility that was released at the same time by the Canada Customs and Revenue Agency (CCRA), IT-533, "Interest Deductibility and Related Issues". The release of IT-533 follows a review by the CCRA of its administrative position on interest deductibility and statements made in this regard at the Canadian Tax Foundation conference in 2002. IT-533 states that it does not take into account the proposed amendments.

Background

The genesis of the proposed amendments can be found in the supplementary material tabled with the 2003 federal budget, which stated that the Department of Finance was reviewing the deductibility of interest and other expenses. The budget materials indicated that the Department of Finance was dissatisfied with recent court decisions in this area that, it believed, could lead to "inappropriate tax results". While no specific cases were identified, the discussion strongly suggested that the decisions of the Supreme Court of Canada in Ludco, Stewart and Walls were troubling the Department.

Under Ludco, absent mere window dressing, a taxpayer need only demonstrate that borrowed money was used for the purposes of earning gross (rather than net) income in order for interest on the borrowed money to be deductible. Under Stewart and Walls, where an activity contains no personal element, it is not necessary for a taxpayer to prove that there is a reasonable expectation of profit in connection with the activity in order for losses from the activity to be deductible. In the view of the Department of Finance, it seems, the principles established in these decisions are inappropriate from a tax policy perspective. Accordingly, the budget materials indicated that legislative amendments would be considered, in order to "restore continuity with the expected [tax] consequences before these recent court decisions". The proposed amendments are the outcome of this process.

Mechanics

Under the proposed legislation, it would be necessary, in each year in which a taxpayer might otherwise realize a loss from a business or property, to assess whether it is reasonable to expect that the taxpayer will, over time, realize a "cumulative profit" from the business or property. This assessment takes into account not only how long the taxpayer has in fact carried on the business or held the property, but also how long the taxpayer is reasonably expected, in that year, to carry on the business or hold the property in the future. This period of time is referred to in the explanatory notes accompanying the draft legislation, but is not defined, as the "profitability time period", an uncertain span that promises to bedevil auditors and judges alike. The term, "cumulative profit", is also undefined. In the explanatory notes, the Department of Finance describes cumulative profit as the aggregate profit or loss over the entire profitability time period. Profit for this purpose is not actual profit but projected profit. Such profit is to be determined without reference to capital gains or capital losses. Evidently, the Department of Finance wishes to engage both the CCRA and the judiciary in evaluating, on a year by year and case by case basis, the reasonableness of taxpayers' business judgment, even though courts have repeatedly emphasized their unwillingness to do so. Notably, the limitation on losses is not symmetrical. A taxpayer may continue to have income from a business or property for a particular year, even where it is not reasonable to expect that the taxpayer will realize a cumulative profit from the business or property.

Potential Problems

The proposals themselves are neither lengthy nor detailed, but their apparent simplicity hides a number of potential problems for taxpayers. For example, it would appear that disallowed losses simply disappear. Arguably, in the case of losses from property, such losses should be added to the adjusted cost base of the property. However, the proposed legislation does not provide for this result. In addition, a reasonable expectation of cumulative profit in a subsequent year does not restore a previous year's disallowed losses, and the proposed legislation does not contemplate revisiting prior years' expectations.

Despite apparent assurances to the contrary from the Department of Finance, the proposed amendments also call into question the deductibility of interest in circumstances where deductibility was widely thought to be unproblematic, including the borrowing of money to purchase common shares. IT-533 confirms that the CCRA "normally" considers interest expenses in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation, at the time the shares are acquired, that the shareholder will eventually receive dividends. It is our understanding, based on recent informal discussions with the CCRA, that the CCRA would be prepared to apply this administrative policy in a manner that ordinarily would not deny losses that result from the deduction of such interest expenses. However, it is not clear how, as a matter of law, this position regarding loans to acquire common shares can be reconciled with the CCRA's apparent position regarding loans to acquire other assets.

The proposed amendments would also create difficulties in the context of the disappearing source rules in the Act. These rules generally preserve the deductibility of interest that would otherwise be deductible after the source of the income to which the interest relates disappears. It is unclear how the reasonable expectation of cumulative profit test would apply in this context. In addition, the proposed amendments would extend an expected profits test, which is more stringent than an income-earning purpose test, to numerous provisions that relate to expenses in circumstances where otherwise acceptable deductions would result in a loss. For example, the deduction of issue or other financing expenses could be denied where the expenses create a loss and the reasonable expectation of cumulative profit test is not met. This may be a concern, for example, in respect of such expenses incurred by limited partnerships that invest in flow-through shares or mutual funds that acquire common shares where the expected source of income is capital gains.

On the whole, the proposed amendments reflect an underlying policy to the effect that it is inappropriate for current deductions to produce losses from a source where the expected profit from that source is a capital gain. It may be debated whether the implementation of these proposed rules in the Act represents a new development or merely the restoration of prior expectations. Although the proposed amendments would not apply until taxation years beginning after 2004, this apparent policy should now be considered in current tax planning. It is noted, however, that the proposed legislation may be revised, as taxpayers and tax professionals have been asked to submit comments on the proposals to the Department of Finance by December 31, 2003.