Restricted Farm Losses (Section 31)
Recently, the Federal Court of Appeal has considered two cases dealing with whether the deductibility of farm losses would be restricted by section 31 of the Income Tax Act. In Kroeker v. The Queen 16 , the appellant and her husband lived on a farm, which they had purchased in 1982, and operated as a partnership. From 1987 to 1992, the appellant worked, full-time, as a controller with a farm implement manufacturing company, while her husband tended to the farm. The farm was a combination grain and cattle operation. The appellant stated that, from 1989 to 1992, there had been a shift in the focus of the farming operation to cattle from grain, which had proven to be unreliable. From 1993 to 1995, the farm had generated losses ranging from about $4,200 to over $42,000 on gross farming revenue of between $83,000 and $108,000. The appellant deducted her share, 50%, of the losses against her net income. The CCRA applied subsection 31(1) of the Act on the basis that there was no evidence that the farm partnership could reasonably be expected to provide to the taxpayer “substantial” profits from farming. The Federal Court of Appeal found that the losses were fully deductible because the appellant’s time, capital, and labour were focussed on the farm, and the farm actually made a profit in 1998.
In Taylor v. The Queen 17 , the appellant had operated the family farm since 1971. From 1987 to 1998, the appellant had gross farm income of between $22,000 and $88,000 and net farm losses of between $2,500 and $50,000. The appellant had also been employed on a full-time basis with a gas refinery for many years. The farm was originally a cattle operation, which had grown from five head of cattle to over one hundred head. The farm changed to a haying operation in 1997 after the cattle were sold due to a bacterial infection. The appellant had invested over $300,000 in the farm, and devoted more time to the farm than to his employment. The CCRA restricted the deductibility of the farm loss under subsection 31(1) of the Act. However, the Federal Court of Appeal found that the losses were fully deductible, consistent with its decision in Kroeker.
Question 1
In light of the decisions in Kroeker and Taylor, would the CCRA comment on its position with respect to the application of section 31 to farm losses?
Response 1
We feel that the decisions in the Kroeker and Taylor cases were based on the particular facts of each case. The rationale used by the court in its analysis of the facts was not inconsistent with our overall approach on determining whether farming, either alone or in combination with another source, constitutes a taxpayer’s chief source of income.
In its analysis, the court commented on the time spent in the farming operation, capital committed to the operation, and actual and potential profitability of the farm. These factors were set down by the Supreme Court in Moldowan v. The Queen 18 , and are used by the CCRA to determine whether farming is the chief source of income for the taxpayer.
The decisions, however, highlight the fact that it may be appropriate in certain cases to place more attention on time and capital committed when making the determination.
Question 2
What approach is taken by the CCRA in determining the deductibility of farm losses?
Response 2
The review of farm losses is a two-step process.
First, we look at the losses to determine if they arise from an income source. If there is no source, then the losses would not be deductible.
Secondly, if the losses are determined to be from a source, then we would consider whether that source, either alone or in combination with another source, constitutes the taxpayer’s chief source of income. If it does not, then the losses would be restricted by section 31 of the Act.
Question 3
In light of the Supreme Court decisions in the Stewart 19 and Walls 20 cases, how would the CCRA evaluate farm losses to determine if they arise from an income source?
Response 3
Consistent with the approach taken by the Supreme Court in the Stewart and Walls cases, we would consider whether the farming activities were undertaken in pursuit of profit, or whether they were simply a personal endeavour. Where there is a personal element to the farming activity, then it must be determined whether the operation is carried out in a sufficiently commercial manner. If so, then any loss arising from these activities would be considered to have arisen from a source of income.
In order to determine whether the farm activities are carried out in a commercial or business-like manner, we would look at all of the facts including the following:
- Amount of capital invested in the farming infrastructure and machinery;
- Taxpayers background and experience in farming;
- Time spent on farming;
- Capability of the operation to show a profit;
- The taxpayers operational plan or intended course of action with respect to the farm;
- The gross revenue and income or losses generated by the farm in the past;
- The scale and manner in which the farm is operated as compared to other commercial farming operations in the area.
Question 4
If the farming operation is carried on in pursuit of profit, how will the CCRA determine if the losses would be restricted by section 31 of the Act?
Response 4
In order to establish whether farming constitutes a taxpayer’s chief source of income, we would compare the farming operation to the taxpayer’s other income sources in terms of time spent on farming, capital committed to the farm operation, and the actual or potential profitability of the farm. All three factors must be weighed, with no one factor alone being decisive.
However, in determining the weight to be given to each factor, we would look at the taxpayer’s normal lifestyle. If the taxpayer has a farming background and his or her lifestyle revolves around the farm, then time spent on, and capital committed to, farming have greater significance. For example, this would be the case where a second-generation farmer takes a job to supplement his or her farming income.
On the other hand, where the taxpayer’s normal lifestyle is not farming, then profitability assumes more importance. This would be the case where a taxpayer, who has ongoing income from employment, a profession, or a pension, has decided to start farming after establishing a non-farming career or retiring. In this situation, the most important consideration is whether the farm has generated, or can be expected to generate enough income to support the taxpayer’s lifestyle.
Question 5
In Donnelly v. The Queen 21 , the Federal Court of Appeal found that there must be a “reasonable expectation of substantial profit” in order for farming to be considered the taxpayer’s chief source of income. In the Kroeker decision, the Court appears to distinguish Donnelly as applying only to cases where horses are raised for racing. In this context, would the CCRA comment on what approach would be taken in situations involving full-time employees, or professionals, who incur losses from the raising of racehorses?
Response 5
We would use the two-step approach outlined above to evaluate the deductibility of losses from a horse racing operation.
In our view, when a full-time employee, or professional, starts raising horses for racing, there is likely a strong personal or “hobby” element to such activities. Therefore, in determining whether the horse racing operation is carried out in pursuit of profit, we would look at all of the facts, including those listed in Question 3 above, to establish if the activity is carried out in a sufficiently commercial manner.
Secondly, in determining whether the activity constitutes the taxpayer’s chief source of income, we would consider the time spent on the activity, the capital committed to the operation, and the actual and potential profitability of the operation. Since the taxpayer’s normal mode of lifestyle is not focussed on farming in the situation presented, the most important factor would be the actual and potential profitability of the operation. In this context, the comments in Donnelly are relevant, and we would consider whether the horse racing operation could be expected to generate substantial profits in relation to the taxpayer’s other income sources.