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CHAPTER 5

INCOME FROM BUSINESS


Key Concept Questions
QUESTION TWO
Sharp Ltd. incurred the following expenses in the current year:
$25,000 in legal and accounting fees with respect to the issue of a new class of
preferred shares.
$8,000 for landscaping around the office building.
$1,200 in interest paid to the CRA for late income tax instalments.
$2,700 in interest on funds borrowed to finance the purchase of new office equipment.
$40,000 in scientific research and experimental development expenditures.
$80,000 in stock-based compensation expense.
Comment on the deductibility for tax purposes of each of the expenses. Income tax reference:
ITA 7(3), 18, 20(1), 37(1), (2).

QUESTION THREE
Gary carries on an accounting business as a sole proprietor. The business is an HST
registrant. In the current year he incurred the following expenses, among others:
$12,312Lease payment for his car (12 months). . Eighty percent of the kilometres
driven were for business purposes.
$1,000Donation to a registered charity.
$5,000Entertaining clients (meals and theatre tickets).
$2,400Golf club annual dues. Many of Garys clients are members of the golf club.
Comment on the deductibility of these four expenses (and the HST implications). Income tax
reference: ITA 18(1), 67.1, 67.3.

Solutions to Key Concept Questions


KC 5-2
[ITA: 18, 20(1), 37(1), (2) Deductions]
The $25,000 legal and accounting fee incurred with respect to the issue of a new class of
shares is a cost of issuing shares and as such is deductible over 5 years [ITA 20(1)(e)].
Therefore, $5,000 is deductible in the current year and in each of the following 4 years.
The $8,000 expense for landscaping is deductible in the current year, provided that the $8,000
was paid in the current year [ITA 20(1)(aa)].

The $1,200 of interest paid to the CRA is not deductible [ITA 18(1)(t)].
The $2,700 of interest paid to finance the purchase of office equipment is fully deductible in
the year incurred [ITA 20(1)(c)]. Interest can, at the taxpayers option, be deducted on a cash
basis when paid, rather than by the accrual method. Alternatively, the interest expense can be
added to the cost of the equipment and deducted over time in the form of CCA [ITA 21].
Scientific research and experimental development (SR&ED) carried on in Canada is given
preferential tax treatment. The expenditures of a current nature are deductible in full in the
year incurred [ITA 37(1)(a) & (b)]. Alternatively, the deduction, or any portion of it, can be
saved and deducted in any future year [ITA 37(2)].
In addition, the SR&ED expenditures may also generate an investment tax credit, which
reduces tax payable [ITA 127(5)]. Investment tax credits claimed in the year, reduce the
SR&ED expenditure pool in the following year or are included in income, if there is no balance
in the SR&ED pool [ITA 12(1)(t), 37(1)(e)].
Stock-based compensation expense is not deductible. The Income Tax Act denies an
employer a deduction in connection with the sale or issue of shares to an employee [ITA 7(3)
(b)].

KC 5-3
[ITA: 18(1), 67.1, 67.3 Deductions denied or limited; ETA: 123(1), 170(1)(a), 236]
Automobile lease payments for tax purposes are limited to $800 plus tax per month [ITA 67.3].
Since Garys accounting practice is an HST registrant, he recovers the HST he pays and, thus,
HST cannot be included as a cost. Thus, the car lease payments for the year are limited to
$800 x 365/30 = $9,733. Gary uses the car 80% for business purposes - $9,733 x 80% =
$7,787. Garys deductible amount is $7,787.
Donations to registered charities are not for the purpose of earning income. They are gifts.
Therefore, no deduction is available [ITA 18(1)(a)]. Donations involve a transfer of money
which is not a supply and, therefore, is outside the scheme of HST. No HST input tax credit is
available [ETA 123(1)].
Fifty per cent of entertainment expenses are deductible [ITA 67.1]. Therefore, Gary can deduct
$2,500. Although an HST input tax credit is initially allowed on the full amount expended for
food and entertainment, there will be a recapture of 50% of the total input tax credit in respect
of these expenses [ETA 236].
Membership dues in any club, the main purposes of which is to provide dining, recreational or
sporting facilities for its members, are not deductible [ITA 18(1)(l)]. Therefore, the golf club
dues are not deductible. HST input tax credits are not allowed in respect of these nondeductible membership fees [ETA 170(1)(a)].

Problems
PROBLEM ONE
[Issue: Capital vs. Income]
X, Y, and Z each purchased an identical piece of land at a cost of $4,000.

X constructed a restaurant on her land and operated it profitably for several


years.
Y did nothing with her land. It simply remained unused for several years.
Z rented out his land for a number of usescar parking, summer carnivals, and
so on.

Reasonable returns were achieved.


Four years later, X, Y, and Z each sold their land for $12,000. X sold the land as part of the
sale of the restaurant business. Y subdivided the land into three separate parcels and sold
each for $4,000. Z had no intention of selling the land but received an offer that he felt he
could not refuse.
Required:
Is the gain on sale of the land ($12,000 $4,000 = $8,000) income from business for X, Y, and
Z? Explain.

Solution to P 5-1
X-

It is apparent that X purchased the land and used it to derive a long term benefit. The
land was used to permit the construction of a building to house a restaurant which
generated revenue. The land is, therefore, capital property and when sold results in a
capital gain of $8,000 ($4,000 taxable).

Y-

It appears that Y acquired the land for the purpose of trading it at a profit and not to
provide a long term benefit. This is evidenced by the fact that the land was not used and
was subdivided into saleable lots. The land may be considered inventory and the gain of
$8,000 fully taxable as business income.

Z-

Z's intention is not as clear. It may be considered as capital property because Z derived
a long term benefit from various rental returns. Also no attempt was made to sell the
property; it was sold after an unsolicited offer which was too good to refuse. On the other
hand, it could be argued that Z made no long term commitments to derive benefits but
instead leased the land for short term and varying uses. This may indicate that the
intention was to trade the land at a profit and avoided long term leases in an attempt to
keep the land free for sale. Therefore, whether this gain is business income or capital
gain is not clear based on the information available.

PROBLEM TWO
[Issue: Capital vs. Income on sale of a licence]
Carl Fenson of Winnipeg owned three taxicabs that operated for 24 hours a day (two shifts of
12 hours). Fenson worked one shift himself and hired drivers for the other shifts. At the time, in
addition to the normal taxi licence, a special licence was required to deliver passengers to
Winnipeg International Airport. This special licence was referred to as a one way licence
because it could be used to deliver passengers to the airport but not to pick up customers
there. The licences were issued for 10-year renewable terms.
In 20X1, Fenson purchased three additional airport licences for $10,000 each, even though he
did not have vehicles for their use. He immediately resold two of the licences for $18,000 each
to a relative. Shortly thereafter, he purchased a mini-van, assigned the third new licence to that
vehicle, and rented the van with the licence to a third party.
In 20X3, Transport Canada converted all one-way licences to two-way licences. In response to
an unsolicited offer, Fenson cancelled the van lease and sold the third licence for $45,000.
Required:
What type of income did Fenson earn from the licence sales? Explain.

Solution to P 5-2
The issue is whether the sale of the licenses creates capital gains or business income.

Sale of two licenses to relatives:


This appears to be an adventure or concern in the nature of trade because he acquired the
licenses for $10,000 each and immediately resold them for $18,000 each. Also Fenson did
not have any vehicles which could use the licenses when acquired.

Sale of third license:


There are two possible arguments for the third license.
1)

The license together with a vehicle was rented to a third party indicating its purpose
of acquisition was to achieve a long-term benefit from rental returns. In addition, it
was only sold when a fortuitous change in the law made the license more valuable
and an unsolicited offer was received. Based on the above, the sale could be
construed as a capital gain.

2)

To the contrary, it may be argued that Fenson's original intention in acquiring the
license was established by the treatment of the first two licenses which were sold at
a quick profit. Therefore, the primary intention of all three licenses was to trade them
at a profit. The history of the past transactions may be relevant. The renting of the
third license may have been a temporary measure until the license could be sold.
Therefore, the gain on the third license may be considered to be business income.

PROBLEM FIVE
[ITA: 18(1)(b), (e), (l); 20(1)(c), (e), (dd); 67.1]
The controller of Mead Pipes Ltd. is completing the preparation of the corporations
20X1 tax return but is uncertain about the tax treatment of the following eight expense items:
1.

Finders fee to obtain a mortgage on the companys buildings

$6,000

2.

Property taxes on the companys new fishing lodge, which is


used by employees

1,200

3.

Interest for late payment of municipal property taxes for the


warehouse

600

4.

Brokers fees for the purchase of publicly traded shares

1,400

5.

Permanent landscaping of land around the head office


buildings

4,800

Cost of investigating a site for a proposed warehouse, when


the site was rejected

2,000

7.

Hockey tickets to entertain customers

1,800

8.

Reserve for the possible costs for guarantees of products sold


in the year

8,000

6.

Required:
Determine the amount by which the preceding items will reduce the net income for tax
purposes of Mead Pipes Ltd. for 20X1. When an item has been totally excluded from your
calculation, provide a brief reason why.

Solution to P 5-5
The items will reduce net income for tax purposes by:
Finder's fee:
This is on account of capital but it is specifically deductible at
1/5 per year as a cost of borrowing [ITA 20(1)(e)].
Interest on late property taxes:
Interest is specifically allowed on items used to earn income
[ITA 20(1)(c)] . The property taxes are deductible and so is the
interest.
Permanent landscaping:
Although this is a capital item, it is specifically allowed as a
deduction in the year paid [ITA (20(1)(aa)].
Investigation of site:

$1,200

600

4,800

This also is a capital item but is allowed as a deduction in the


year paid [ITA 20(1)(dd)].
Hockey tickets:
Deductible as a promotion expense but is limited to 50% of
$1,800 [ITA 67.1]

2,000

900
$9,500

The following items were excluded:


o

Property taxes on fishing lodge - specifically denied as a deduction [ITA 18(1)(l)].

Broker's fee - is a capital item and thus, not deductible [ITA 18(1)(b)]. It is added to the
cost of the shares.

Reserve for product guarantees - Denied by the general rule that reserves are not
permitted [ITA 18(1)(e)]. No exception is provided for this specific type of reserve.

PROBLEM SIX
[ITA: 18(1)(b), (e), (l), (n); 19(1); 20(1)(a), (e), (cc)]
Central Products Ltd. is in the process of completing its 20X0 financial statements and tax
return. A junior accountant has given you a list of items that he does not know how to treat for
tax purposes. The list includes the following eight items:
1.
2.

Purchase price of a patent giving the company exclusive rights to


manufacture a product
Cost of annual dues to a golf club for three senior salespeople to entertain
existing and potential customers

3. The union contract expired four months before the year end and
bar gaining is still in process. A 3% wage increase is expected, and the
company has recorded a reserve to cover the four-month period
4.

$120,000
8,000

60,000

Legal fees paid for making a representation to a provincial


government against a proposal to introduce a payroll tax

15,000

5.

Donations paid to a registered charity

10,000

6.

Advertising in a foreign trade newspaper that was distributed to


Canadian customers

4,000

Travel costs (airfare and lodging) for a senior executive to visit a


Foreign supplier to inspect and sign a purchase agreement for a
new manufacturing machine. The machine was delivered and used in 20X0

3,000

7.

8.

Legal, accounting, and printing costs to prepare a prospectus


offering common shares for sale to the public

32,000

Required:
Describe how each of the above items will be treated for tax purposes for the 20X0 taxation
year.

Solution to P 5-6
1.

Patent - capital item and is denied a full deduction by the general rules [ITA 18(1)(b)]. It
qualifies for a deduction over time by capital cost allowance [ITA 20(1)(a)] (see Chapter
6) - class 44 - 25% x $120,000 x 1/2.

2.

Club dues - for the purpose of earning income but is denied a deduction [ITA 18(1)(l)].

3.

Wage reserve - denied a deduction under the general rule that disallows reserves [ITA
18(1)(e)].

4.

Legal fees for representation - capital item but is specifically allowed as a deduction in
the year paid [ITA 20(1)(cc)].

5.

Donations not an expense to earn income. They are gifts. Therefore, not deductible in
the computation of business income [ITA 18(1)(a)].

6.

Foreign advertising - is for the purpose of earning income but, because it is directed to a
Canadian market, the deduction is denied [ITA 19(1)].

7.

Travel cost - capital item because it is part of the cost of acquiring equipment. The full
amount is denied a deduction under the general rules [ITA 18(1)(b)]. The amount
qualifies for capital cost allowance as part of the manufacturing equipment cost (see
Chapter 6) - Class 29, $3,000 x 25% in 20X0, the year of acquisition.

8.

Prospectus costs - are actually capital items (costs of arranging financing) but can be
deducted over five years at the rate of 20% per year ($32,000 x 20% = $6,400) [ITA
20(1)(e)].

PROBLEM SEVEN
[ITA: 9(1); 18(1)(b), (e), (h), (l); 20(1)(a), (e), 20(10); 34; 37(1); 67.1; 67.2]
Simone Cherniak has just completed the second year of operating her veterinary clinic. You
have been retained by Cherniak for tax assistance and advice. At a recent meeting, you
gathered information on her practice, which is presented below.
For the year ended December 31, 20X2, the clinic showed a profit of $123,700, as follows:
Professional service
Gross profit from surgical instrument sales
Administration and other expenses

$321,000
28,000
349,000
228,300

Interest income
Net income

120,700
3,000
$123,700

Included in the above is depreciation/amortization expense of $23,000 on fixed assets and


amortization of development costs of $4,400. Additional information is outlined below.
1.

On February 28, 20X2, Cherniak purchased a competitors business and merged it with
her own. The following assets were acquired:
Truck
Equipment

$ 18,000
50,000

2.

During the year, Cherniak designed and patented a new surgical instrument. On July 1,
20X2, a legal fee of $4,000 was paid for the patent (life of 20 years) registration; this
amount is included in administration expenses. In October, $16,000 was spent on
consultants to research metal alloys, and this cost is being amortized as development
costs in the financial statement.

3.

Professional services revenue includes the value of unbilled services compiled from a
work-in-progress file. At December 31, 20X2, unbilled services amounted to $27,000,
compared with $18,000 at the same time last year. In 20X1, Cherniak had made an
election under section 34 of the Income Tax Act to exclude work in progress from
income.

4.

Some of the items included under administrative and other expenses are as follows:
Group life insurance for office staff
Christmas gifts to staff (under $200 each)
Dues to golf club (for employee)
Meals and drinks for clients
Books (15-volume set on veterinary medicine)
Interest on car loan (six months)
Finders fee for a loan to finance equipment

$1,100
1,400
1,200
400
3,000
2,100
1,000

5.

The income statement includes a cost of $3,150 for attending three conventions during
the year. Convention #1 ($750) was in July 20X2. Conventions #2 ($1,350) and #3
($1,050) were both in December 20X2. Each convention includes a cost of $100 for
meals. For each of the December conventions, the airfare of $200 was included in
accounts payable at the end of the year.

6.

Vehicle costs include operating costs of $2,400 for the automobile (including $400 for
car parking). The automobile was driven 24,000 km. Of this, 12,000 km was for
customer travel, 2,000 km was for travel between her home and the clinic, and 10,000
km was for personal travel.

7.

Cherniak expects that a number of the new manufactured surgical instruments will be
returned for modification, which she will do at no extra cost to the customer. The
income statement includes a $2,000 deduction based on her estimate of the returns. As
of December 31, 20X2, $800 of costs were incurred for returned items.

8.

Cherniak moved from rented premises to new rented premises on February 28, 20X2,
with 20 months remaining on the old lease. The landlord accepted a payment of $8,000
in exchange for cancelling the lease. The accounting records have amortized this cost

over the remainder of the lease term and accordingly have deducted $4,000 ($8,000 x
10 m/20 m) as rent expense.
9.

Capital cost allowance (CCA) for tax purposes has been correctly calculated as
$15,000.

Required:
Determine Cherniaks income from business for tax purposes for the 20X2 taxation year.
Identify any other sources of income that are taxable in the year.

Solution to P 5-7
Income from business 20X2:
Income per financial statements [ITA 9(1)]
Interest income - is property income
Depreciation [ITA 18(1)(b)]
Amortization of development costs [ITA 18(1)(b)]
Patent cost (capital item) [ITA 18(1)(b)]
- qualifies for capital cost allowance
Research and development - actual [ITA 37(1)]
Work in progress exclusion ($27,000 - $18,000) [ITA 34]
Club dues [ITA 18(1)(l)]
Meals ($400 x 50%) [ITA 67.1]
Book set (capital item) [ITA 18(1)(b)]
- qualifies for capital cost allowance
Car loan interest ($2,100 ($300 x 6 months)) [S 67.2]
Finders fee on loan ($1,000 x 4/5) [ITA 20(1)(e)]
Convention expenses (limited to 2 conventions)
(Expenses must be paid) [ITA 20(10)]
Exclude convention #1 (the lowest cost)
Meals for #2 and #3 (50% x ($100 + $100)) [ITA 67.1]
Airfare not paid in 20X2 ($200 x 2)
Personal portion of auto [ITA 18(1)(h)]
($2,400 - $400 parking = $2,000 x 12,000/24,000)
Reserve for return sales less actual returns
($2,000 - $800) [ITA 18(1)(e)]
Lease cost - full cost allowed
($8,000 - $4,000 already deducted)
Capital cost allowance [ITA 20(1)(a)]
Income from business

$ 123,700
(3,000)
23,000
4,400
4,000
(16,000)
(9,000)
1,200
200
3,000
300
800
750
100
400
1,000
1,200
(4,000)
(15,000)
$117,050

The only other source of income is property income - interest of $3,000.


Note: The purchase of the truck, equipment, patent, and books are all capital costs and qualify
for capital cost allowance.

PROBLEM ELEVEN
[ITA: 3; 6(1)(c); 8(1)(b); 12(1)(c); 31; 38(a), (b), (c); 60(0); 63]
Sharon Cloutier is semi-retired and sits on the board of directors of several Canadian public
corporations. A summary of her 20X0 financial activity is presented below.
Interest on long-term bonds
Gain on sale of farmland (Cloutier acquired the farmland three years
ago with the intention of subdividing it into building lots for
resale but sold it in 20X0 after losing a rezoning application.)
Directors fees from public corporations
Gain on sale of public corporations shares
Legal fees paid to collect a bonus on a former employment contract
Legal fees paid to dispute an income tax reassessment
Loss on sale of shares of a Canadian-controlled private corporation
that qualifies as a small business corporation
Loss on sale of public corporation shares
Share of the operating loss from a partnership that operates a small
grain farm with hired help
Qualified moving expenses

$20,000
13,000
22,000
16,000
2,000
1,500
8,000
20,000
18,000
1,000

Required:
Determine Cloutiers income for tax purposes in accordance with section 3 of the Income Tax
Act.

Solution to P 5-11
Income for tax purposes:
ITA 3(a) Employment income:

Directors fees [ITA 6(1)(c)]


Less legal fee - bonus [ITA 8(1)(b)]

Property income:
Interest [ITA 12(1)(c)]

Business income:
Land sale

ITA 3(b) Taxable capital gain:

Public shares - (16,000)


Allowable capital loss:

Public shares - (20,000)

$22,000
(2,000 )
20,000
20,000
13,000
53,000
$8,000
(10,000 )

0
53,000

ITA 3 (c) Other deductions:

Moving expenses [ITA 63]

Legal fees - reassessment [ITA 60(o)]


ITA 3(d) Losses:

(1,000)
(1,500)

(2,500 )
50,500

ABIL - x $8,000
Farm loss * [ITA 31] - lesser of:
$2,500 + 1/2(18,000 - 2,500) = 10,250
$18,000 (actual loss)
$17,500 (limit)

Income for tax purposes

(4,000

(10,250)

(14,250)
$36,250

* Chief source of income is not farming. Therefore, the farm loss is restricted.