Monday, April 5, 2004

New REOP - But is it Reasonable?

Second-guessing may be on its way back, starting in 2005.

The federal government has released draft income tax legislation that would have a significant impact on one’s ability to claim tax losses from business ventures or investments.

The proposed rules would be effective for 2005 and later taxation years. Under the proposals, a taxpayer would be able to deduct a business or investment loss only if the taxpayer could show that the business or investment had a “reasonable expectation of profit”. For a long time, income tax authorities attempted to deny the deduction of losses by arguing that the taxpayer could not reasonably have expected to profit from the venture in question. In an earlier decision, the Supreme Court of Canada expressly rejected this approach as a general test for deductibility. The draft legislation would effectively reverse this court decision.

The new statutory “reasonable expectation of profit” test would apply to all business and investment ventures. While the taxpayer would not have to show actual profit in any specific year, the taxpayer would have to be able to show on a year-by-year basis that the taxpayer had a reasonable expectation that the venture would show a cumulative profit over the time that the taxpayer expected to operate the business or hold the investment.

In computing profit for the purpose of applying the reasonability test, capital gains are ignored.

This could have far-reaching implications. For example, take the case of an investor who borrows money to acquire shares of a publicly-traded corporation. The investor may expect to receive dividends but – more likely than not – the investor may well be looking to the eventual sale of the shares for most of his or her “profit”. Under the draft legislation, any capital gain that arises on the sale of the shares would not count when determining whether the investor had a “reasonable expectation of profit”. That expectation would have to be judged by comparing the investor’s interest expense with the dividends expected over the life of the investment.

What if the investor acquires shares of a corporation that has expressly adopted a no-dividend policy for the foreseeable future as the corporation invests its earnings in rebuilding infrastructure?

The draft legislation would also apply to real estate investors. Any expectation of profit from a rental property would have to be based on the anticipated cumulative rental income from the property. Expectation of a capital gain on sale would not justify the deduction of annual operating losses.

Perhaps the biggest concern arising from the draft legislation is its potential chilling effect on risky and innovative ventures. It can take years to turn a profit in some ventures. When does an expectation of profit become unreasonable? If the venture fails (as can happen in even the best-planned ventures), will taxation authorities not use hindsight (as they have in the past) to argue that no reasonable person could have expected profit from such a failure? And what about the successful venture that should have failed but succeeded in spite of all “reasonable” expectations?

The proposed rules have been released for public comment. Subject to changes that may result from the public comment procedure, the rules would come into effect in 2005. It will be interesting to see whether the public views the proposed rules as “reasonable” ones.

-- Blair P. Dwyer

The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.