When a taxpayer carries on a farming business (i.e., the taxpayer has a reasonable expectation of profit for that business), but the taxpayer's chief source of income is not derived from farming or a combination of farming and some other source of income (the "combination test"), subsection 31(1) of the Act restricts the taxpayer's deductibility of losses from farming against other sources of income. The maximum allowable annual deduction for a farm loss is restricted by a formula in subsection 31(1) to $8,750. Any unclaimed farm loss is considered a "restricted farm loss" under subsection 31(1.1) of the Act and is available for carryover.
In Moldowan, a landmark restricted farm loss case, the SCC classified a taxpayer for which "farming may reasonably be expected to provide the bulk of income or the centre of work routine" as one whose farm losses would not be restricted for tax purposes.
In Gunn v. Canada, the FCA considered the "combination test" and concluded that it is not necessary for a farmer with a combined source of income activities to have farming as the predominate source. The FCA said that this view would "avoid the judge-made test that requires farming to be the predominant element in the combination of farming with the second source of income...".
In this case, the taxpayer (Mr. C) received his primary source of income from his law practice. He also had income from investments, stock options and farming (buying, selling, training and maintaining horses for racing).
From 1986 to 2008, Mr. C experienced farm losses in 16 out of the 22 tax years. He deducted these losses from the horseâ€‘racing business from his other income. Based on Moldowan, the CRA reassessed Mr. C to restrict his farming losses of approximately $428,000 for his 2000 and 2001 taxation years to $17,500 ($8,750 per year) on the grounds that the combination of the law practice and the horseâ€‘racing business was not Mr. C's chief source of income. The remaining unclaimed farm losses of $410,500 ($428,000 less $17,500) were assessed by the CRA to be "restricted farm losses" that could only be deducted against future farming income.
Lower court decisions
Following the FCA's earlier decision in Gunn, which conflicted with the Moldowan interpretation of the "combination question", the TCC allowed Mr. C's appeal (2009 TCC 617), finding that the loss deduction limitation in subsection 31(1) did not apply. The FCA dismissed the CRA's appeal (2011 FCA 22) on the basis that it was required to follow its prior decision in Gunn.
The SCC concluded that the Moldowan approach to the "combination question" related to chief sources of income is incorrect, and it revisited the interpretation of section 31, which provides for two distinct exceptions to the loss deduction limitation under subsection 31(1). The SCC noted that a judge-made rule that reads one of these exceptions "out of the provision cannot stand".
Taking a contextual approach, the following relevant factors should be considered when interpreting section 31:
- The capital invested in farming and the second source of income
- The income from each of the two sources of income
- The time spent on the two sources of income
- The taxpayer's ordinary mode of living, farming history, and future intentions and expectations.
If these factors tend to show that the taxpayer places a significant emphasis on both his farming and non-farming sources of income, such a combination should constitute a chief source of income and avoid the application of the loss deduction limitation of subsection 31(1). While both endeavours must be significant to the taxpayer, they do not need to be connected, and farming does not need to be the predominant source of income. The SCC noted that this determination is a factual one, and must be flexible, recognizing that not each factor need be significant. Such an interpretation is consistent with the general policy of the Income Tax Act that allows taxpayers to generally offset losses from one business or source of income against profits from another without limitation.
As a result of its analysis, the SCC dismissed the CRA's appeal. Therefore, Mr. C was able to deduct $428,000 (rather than $17,500) of farming losses against other income he earned in 2000 and 2001.
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