Latest Tax Court Ruling on Why Preparing Financial Statements is Important to Receive Tax Benefits

Recently the Tax Court of Canada (Stroud v. The Queen, 2022 TCC 86) ruled that a taxpayer who owned a horse farm could not claim Input Tax Credits (“ITCs”) on the basis that he did not have a “reasonable expectation of profit”

Facts

Here are the facts. The Taxpayer has owned a horse farm since the 1990s. The business was not profitable. For example, from 2010 to 2015, he incurred over $4 million in losses. The Taxpayer also incurred expenses that he claimed ITCs on.

Issue

The issue that the Court had to rule on was whether the Taxpayer was allowed to claim ITCs. In other words, can the Taxpayer get back some of the HST he paid on his expenses?

Ruling

The Court ruled that in this case, the Taxpayer was not allowed to claim ITCs.

To claim ITCs, a claimant must show that he or she made supplies “in the course of a commercial activity.” Whether he or she made supplies in the course of a commercial activity depends on whether the Taxpayer carried on his farm business with a “reasonable expectation of profit.”

There was no question that the Taxpayer, in this case, carried on the business of running a horse farm.

The big question was whether he was doing so with a reasonable expectation of profits.

The Court ruled that the Taxpayer did not carry on a business with a reasonable expectation of profits for the following reasons:

1. The Taxpayer did not file income tax returns for the past few years (over two years).
2. Moreover, the business continued to suffer losses, yet the Taxpayer never prepared any financial statements or similar documents— not even a simple profit and loss statement — to diagnose and treat the underlying financial issues at the farm.
3. In cross-examination, the Taxpayer did not have a good grasp of how much money he spent or his revenues in a given year.

The absence of any financial statements or similar records for an extended period caused the Court to doubt that the Taxpayer had a reasonable expectation of profit from the farm:

• he was unable to objectively discern the root causes of the farm’s lack of profitability
• he could not objectively assess the effect of his efforts to reduce farm losses.

The Court ruled that the Taxpayer did not have the tools to diagnose the underlying causes of the farm losses. Therefore, he could not reasonably expect to cut those losses. The expectation of profit must be “reasonable.” A mere hope or desire for profit is insufficient to meet the “reasonable expectation of profit” test.

Key Takeaway

Many business owners put off preparing financial statements and tax returns because they incur losses. Many businesses that incur losses may still receive government benefits or payments, such as ITCs. This ruling is significant because it highlights that the lack of discipline in monitoring the business through financial statements or similar reports gives off the impression that you may not have a reasonable expectation of profits. This could prevent you from claiming expenses and ITCs.

If you are behind on your accounting and taxes, feel free to let us know, and we can get you back on track.