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Solutions to Chapter 4 Assignment Problems

55

CHAPTER 4

Income from Business: General Concepts and Rules


Problem 1
[ITA: 9; IT-218R]
A piece of land was purchased by Yacumflastor Corporation Ltd. for the purpose of constructing a high-rise
residential building. Plans were made for the development of the property, surveys were made and the land was
stripped and excavated in preparation for construction. Subsequent to this work on the land, it was determined
that the location was not suitable for the intended purpose, due to heavy truck traffic in the area. As a result, the
property was listed for sale with the realtor who acted in the original purchase. The sale at a substantial profit
took place approximately six months from the purchase.
The corporation had been newly formed when the above land was purchased. At about the same time,
another piece of land was purchased and was developed into a commercial/industrial plaza which the corporation
continues to own as a rental property. The principal shareholder of the corporation, Jake Yacumflastor, owns and
operates an electrical contracting business.
The Articles of Incorporation of the corporation contain the following statement of objects:
... to purchase, lease, acquire, hold, manage, develop, operate, pledge and mortgage, either
absolutely as owner or by way of collateral security or otherwise, alone or jointly with others and
either as principal or agent, property, real or personal, and assets generally of any and every kind
of description.
No mention is made of the purchase and sale of land as a business activity.
REQUIRED
Write a memo for the Yacumflastor Corporation Ltd.s file evaluating the issue of whether the sale of the
land should be treated as a receipt of income or capital gain for tax purposes. Arrive at a conclusion consistent
with your analysis of the facts, but indicate the basis for any areas of potential opposition to your conclusion.

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Introduction to Federal Income Taxation in Canada

Solution 1
Intention of the Taxpayer
(A) Primary intention: The corporation intended to construct an apartment building on the property, not to
purchase the property itself for resale at a profit. Unexpected circumstances resulted in the sale of the property.
These statements of intention must be substantiated by facts which can be observed objectively, as discussed
below.
(B) Secondary intention: The question of whether the corporation intended, at the time of purchase and as a
motivation for the purchase, to resell the property at a profit if the primary intention was frustrated must be
answered by reference to other factors discussed below.
Factors Used to Substantiate the Intention of the Taxpayer
(A) Relationship of the transaction to the corporations business: The corporation was not normally in the
business of buying and selling land. This was a relatively new corporation at the time of the transaction. In
addition to the land which it sold, it purchased another property which it has developed into a
commercial/industrial plaza and which it holds as a rental property. Furthermore, the principal shareholder of the
corporation owns and operates an electrical contracting business and, thus, cannot be said to be in the business of
buying and selling land.
(B) Nature of the activity surrounding the transaction: The transaction involving the sale of the property
should not be considered of a business nature or an adventure in the nature of trade. The sale was made only
after it was determined that the property location was not suitable for development into an apartment building. It
was listed for sale with the realtor only at that time and not immediately after purchase. It could be argued that
the minor improvements made were to make the property more marketable for resale purposes.
(C) Type of asset: The land was to be developed for an apartment building used for rental purposes and,
hence, would have been considered a capital asset rather than inventory. Plans were made for the development of
the property to the extent that surveys were made and that the land was stripped and excavated in preparation for
construction. The fact that no income was ever earned from the property as a capital asset could be used to
suggest it was held as inventory.
(D) Number and frequency of transactions: Since this is a new corporation and the transaction in question
was the first of its nature, there is no track-record on which to base an assessment of number and frequency
despite a short (i.e., six-month) holding period. As a result, this should not be a determining factor in this case.
(E) Articles of incorporation: There is nothing in the Articles of Incorporation to suggest that the
corporation can engage in the purchase and resale of land as a business activity. On the other hand, the articles
are very broad and might be interpreted to encompass this type of business activity.
(F) Other factors: IT-218R, paragraph 3 suggests other factors which might be considered in the evaluation
of real estate transactions, including:
(i) the feasibility of the taxpayers intention;
(ii) the geographical location and zoned use of real estate acquired;
(iii) the extent to which borrowed money was used and the terms of the financing;
(iv) the length of the holding period (relatively short, i.e., 6 months, in this case);
(v)
factors which motivated the sale.
Conclusion
From the foregoing analysis of the facts, it is reasonable to conclude that the profit realized on the sale of the
property was a capital gain. The intention to develop the property as an income-producing capital asset, in the
same manner as the development of the other property, is substantiated by the nature of the transaction, the type
of asset and the Articles of Incorporation.

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While it may be possible to argue that the corporation had a secondary intention to sell the property at a
profit, if the primary intention of developing it as a capital asset was frustrated, the evidence is not strong for that
argument. Such a secondary intention is best supported by evidence of a person, such as a realtor, who is
knowledgeable in the real estate market. Neither the corporation nor its principal shareholder was engaged in the
real estate business or could be said to have specialized knowledge of real estate markets, unless the electrical
contracting business can be considered to provide special real estate knowledge and insights. Furthermore, the
property was not listed or made available for sale immediately after purchase, but only after the location was
found to be unsuitable.
It is possible to regard the amount of development activity as consistent with holding the land as inventory
for resale, but relative to the other facts supporting a capital transaction the income receipt alternative is less
likely.

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Introduction to Federal Income Taxation in Canada

Problem 2
[ITA: 18(l)(a), (h); 248(1)]
The taxpayer, in 1959, purchased 200 acres of property in the Calabogie area of Lanark, as a holiday
property for himself and his family. In 1961 it became their principal residence. He worked in Ottawa, both at
that time and in the subsequent years; initially he commuted between the Lanark property and his Ottawa job on
a daily basis. In the early 1970s he began living in Ottawa during the week and commuting home to the property
only on weekends. When the property was first purchased, there was an old brick house on it which was not
suitable as a residence for the family. A new house (referred to in the evidence as the D.V.A. house) was built; the
family moved into it. It is clear that the familys lifestyle was such as to enjoy the rural location.
In 1974 the taxpayer decided to turn part of the property into a campground; 8 serviced campsites and
approximately 12 unserviced sites were created for this purpose. There was as well room for at least 10 other
unserviced campsites more or less immediately available and potential for expansion to a much larger number
(e.g., 100). Outhouses were built; a trout pond constructed; and the requisite service roads installed. The tax
treatment of the expenses incurred with respect to this construction is not part of the dispute in this case.
After these initiatives had been taken, sometime towards the end of 1975 or the beginning of 1976, the
taxpayer sought the advice of a consultant with the Ontario Ministry of Tourism, a Mr. Bingham. The advice
sought was with respect to the possibility of developing the campground and obtaining a business loan for this
purpose. The taxpayer had applied in early 1975 for a loan and was turned down in September of that year.
The taxpayers consultations with Mr. Bingham in the later half of 1975 and beginning of 1976 led to
suggestions for the development of the campsite through the construction of additional facilities: additional
serviced sites; proper toilets; laundry facilities; a store on the property; a swimming pool; an activities building
which might be used by the campers in bad weather. The taxpayers accountant, Mr. McCoy, in early 1976
prepared projections as to the proposed profitability of the venture if the proposed development took place. These
projections showed losses in the first year (197677) but a profit thereafter. The projections were based on
information given to Mr. McCoy by the taxpayer and they envisaged the obtaining of a $280,000 loan. The
taxpayer applied to the Eastern Ontario Development Corporation, in 1979, for a loan ($45,000, not $280,000).
Mr. Bingham was asked to evaluate the loan application from the Department of Tourisms point of view. He was
asked to consider: whether the taxpayer had the management capability to effect and operate the proposed
development; whether there would be any negative effects on competitors in the area if the development took
place; whether the taxpayers marketing plans looked reasonable. Mr. Binghams evaluation did not involve any
financial analysis of the application. Mr. Bingham recommended that the loan application go forward for the next
step, evaluation by the Eastern Ontario Development Corporation. The taxpayer was unable to obtain the loan,
because the Eastern Ontario Development Corporations funds are new money for new projects.
The taxpayer purchased a pre-fab house for $40,000 which was constructed across the road from the
D.V.A. house. The family moved into that house in January of 1980. The taxpayer contends that he had decided
to proceed with the plans for the development of the campsite by turning the D.V.A. house into the general
activities building envisaged in the projected development. He states that he planned to add laundry facilities,
toilets, etc., thereto. During 1980, the taxpayer rented the D.V.A. house to his daughter for $100 per month. This
was not sufficient to cover the mortgage costs of the property. In May of 1980 the taxpayer had a massive heart
attack. He was incapacitated until at least September of that year. The taxpayer continued to charge the mortgage
expenses of the property as a business expense.
The profit and loss record of the taxpayers business never showed a profit from the first year of its
operation, in 1975 to 1985. The taxpayer has consistently reported losses: $7,985.54, $8,676.84, $8,383.37,
$14,491.57, $24,414.44, $14,350.77, and $14,508.35 for the 19771983 years, respectively. The gross income for
the campground itself for the years 1977 to 1980 was $86, $134, $258, and $520, respectively. After 1980, the
campground income was reported in a combined fashion with that received from the cottage and farmhouse
property; therefore, it cannot be separately identified. The evidence is sketchy with respect to the renting of the
cottage, the farmhouse and the D.V.A. house. That which exists does not show a vigorous and concerted effort to
run a business. The D.V.A. house, as well as being rented to the taxpayers daughter for $100 per month in 1980,
was rented during a few of the winter months in 1981-82 to some loggers and for approximately six months in
1984 to some miners who were prospecting in the area.

Solutions to Chapter 4 Assignment Problems

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Camp Coupland was listed in a Government of Ontario camping brochure published for the 1981 season and
the taxpayer had had some calling cards made with Camp Coupland, the address, a map and rates listed thereon.
No expenses for advertising of the Camp were included in his 19751985 tax returns.
REQUIRED
Determine whether expenses incurred by the taxpayer during the 1980 and 1981 taxation years are business
expenses that are deductible for tax purposes.

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Introduction to Federal Income Taxation in Canada

Solution 2
[Reference: Coupland v. The Queen, 88 DTC 6252 (F.C.T.D.)]
The following has been edited from the Courts decision (which preceded the Stewart decision, 2002 DTC
6969 (S.C.C.)).
The issue to be determined is purely one of the fact: did the [taxpayer] during the years in question
incur the expenses for the purpose of producing income from a business, that is, was he engaged in an
activity with a reasonable expectation of making a profit therefrom.
I could not conclude on the basis of the evidence in this case, that the expenses in question were
incurred by the taxpayer for the purpose of producing income from a business. I do not conclude that
the activities in which the [taxpayer] was engaged were carried on with a reasonable expectation of a
profit.
My conclusion that the [taxpayers] activities were not carried on with a reasonable expectation of
profit, is based on the reasons which follow. The profit and loss record of the [taxpayers] business
never showed a profit from the first year of its operation, in 1975 to 1985.
With respect to the taxpayers training, I have no doubt that the [taxpayer] had adequate
managerial and the other abilities to develop the campground and run the operation had he chosen to do
so as a serious business venture, and, had he had the capital to do so. His past experience in various
managerial functions, albeit not in the private sector, and his obvious ability to deal well with people
would have made him an ideal candidate to operate such a business. And, in any event, the running of a
campsite is not a high skill occupation.
While I have no doubt that the [taxpayer] had the experience and ability to run a campground
operation as a business, he was not in fact doing so. He was not on the property much of the time. He
had a full-time job in Ottawa during the whole period and only returned to the Lanark property on
weekends. There is no evidence of a concerted effort to try to ensure a full occupancy rate of even the
limited number of campsites which were in existence. (By full occupancy I mean what would constitute
average occupancy in the industry.)
There is no evidence of any concerted advertising of the campground property. There is no
evidence of any definite or specific plans for conversion of the house merely the [taxpayers] vague
statement that this was intended.
Mr. Binghams evidence was that the business was marginally viable in 1976 and that with the
expansion of the facilities, the business could become truly viable. I have no doubt that the operation
of a campground in the area might be a viable enterprise especially had the suggested improvements
been made. But, the issue is whether the business, as the [taxpayer] was operating it, was one which
was being run with a reasonable expectation of profit. I do not think it was.
Note that the case of Tonn et al. v. The Queen, 96 DTC 6001 (F.C.A.), has commented on the applicability of
the reasonable expectation of profit test. In that case, the Federal Court of Appeal indicated that where there is no
personal benefit element, that is, the venture is of a purely commercial nature, the application of the test may not
be appropriate. In the particular case at hand (i.e., the Coupland case), however, there was a personal element to
the fact situation, since the property was purchased as a holiday property for the taxpayer and his family and it
became their principal residence. Later, a house on the property was occupied by the taxpayers daughter at a rent
that was not sufficient to cover the mortgage costs of the property. Therefore, it would appear that under this fact
situation, application of the test is appropriate.
The Supreme Court of Canada, in the Stewart case, established a pursuit of profit source test, which
requires analysis, where there is some personal or hobby element to the activity in question. Since a personal
element was found to exist in this case, the question of whether the taxpayer intended to carry on a business for
profit must be addressed and it was, as is evident from the above excerpts from the decision.

Solutions to Chapter 4 Assignment Problems

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One approach to addressing the issues of this case is to apply the checklist of factors in Exhibit 4-2 in
Chapter 4 of the text to the facts of this case, to the extent that they are known. The Exhibit is reproduced here
for that purpose. Recognize, however, that this list of factors was developed from U.S. jurisprudence which has
no legal precedent status in Canada.

Exhibit 4-2
Checklist of Factors Used to Determine the Existence of a Reasonable
Expectation of Profit or of Operating in a
Businesslike Manner
(1) Manner in which activity is operated:
(a) activity held out to community as a business
(b) activity operated in a businesslike manner
(c) operated in manner similar to comparable profitable businesses
(d) unsuccessful methods discontinued and new ones adopted
(e) formal books and records maintained
(f) separate bank account maintained
(g) record keeping system provides for the determination of segment profits and relevant costs
(h) detailed non-financial records maintained
(i) operating methods changed to improve profitability
(j) level of advertising or promotion undertaken
(k) development plan formulated and followed
(1) scale of operations sufficient to be profitable.
(2) Elements of personal pleasure or recreation:
(a) taxpayer obtains personal pleasure from the activity
(b) facilities are utilitarian
(c) conduct of activity involves social or recreational functions (apart from the activity itself)
(d) long-time interest in activity as a hobby
(e) operating methods constrained by personal motives
(f) personal use separately accounted for.
(3) Expertise of the taxpayer or his advisers:
(a) prior experience in the activity
(b) profit potential determined prior to entry
(c) pre-entry advice (or prior preparation) sought and followed
(d) post-entry advice sought and followed
(e) taxpayer belongs to business-related associations
(f) new or superior techniques developed.
(4) History of income and loss:
(a) average ratio of receipts to disbursements
(b) percentage years receipts less than disbursements
(c) average magnitude of losses
(d) trend of losses declining

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62
(e)
(f)
(g)
(h)
(i)

number of years activity was operated


losses due to circumstances beyond taxpayers control
percentage of years with profits
reasonable start-up period
trend of gross revenues.

(5) time and effort expended:


(a) competent and well-informed manager employed
(b) competent labour employed
(c) average time spent on activity by taxpayer
(d) taxpayer withdrew from another business to devote most of his/her time to the activity
(e) taxpayer did physical labour.
(6) Financial status of taxpayer:
(a) taxpayers average income before activity loss
(b) extent of tax savings from net losses
(c) average ratio of activity losses to other income
(d) taxpayer maintains an extravagant standard of living
(e) majority of taxpayers other income is from investments
(f) extent of other net assets of taxpayer
(g) amount of capital invested in the operation.
(7) Amount of occasional profits:
(a) ratio of average profit to average loss
(b) amount of largest profit earned
(c) ratio of net losses to net assets.
(8) Sale or discontinuance of activity:
(a) activity sold or discontinued because no chance for profit
(b) activity sold or discontinued for any reason.
(9) Success of taxpayer in other activities:
(a) extent of experience in similar successful business
(b) history of losses in a similar activity.
(10) Expected appreciation of asset value:
(a) taxpayer expected property to appreciate in value as the major source of investment return.
Sources: Jane O. Burns and S. Michael Groomer, An Analysis of Tax Court Decisions That Assess the Profit Motive of
Farming-Oriented Operations, The Journal of the American Taxation Association, Fall 1983, pp. 23-39.
Jack Robison, Tax Court Classification of Activities Not Engaged in for Profit: Some Empirical Evidence, The Journal of the
American Taxation Association, Fall 1983, pp. 7-22.

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Problem 3
[ITA: 12(1); 18(1); 20(1); IT-442R]
TalkTech Inc. is a manufacturer and wholesaler of cellular communication products. TalkTech Inc.s
customers are retailers who promote TalkTech Inc.s products to the general public. TalkTech Inc. has an October
31 year-end. You are conducting a review of TalkTech Inc.s year-end accounting records for its 2006 fiscal year
and have been provided with the following information.
TalkTech Inc. has the following recorded reserves:
Account
Opening
Additions Subtractions
Closing
Warranty reserve
$35,000
$10,000
$17,500
$27,500
Allowance for
32,000
7,500
5,000
34,500
doubtful accounts
TalkTech Inc. provides a 1-year warranty on most of its products. The warranty is for defects in
workmanship or component parts. This warranty is provided as part of the purchase price of TalkTech Inc.s
products. TalkTech Inc. honours its own warranties. The 2006 addition of $10,000 represents a standard
percentage of sales made in the 2006 fiscal period. The 2006 subtraction of $17,500 represents an amount
actually paid to honour warranties.
The addition of $7,500 to the allowance for doubtful accounts is a result of the application of TalkTech Inc.s
annual year-end aging analysis. In conversation with the controller of TalkTech Inc. you determine that this
$7,500 increase in the allowance for doubtful accounts was computed by applying the companys historical
collection percentages to the aged accounts receivable balances. Also, during its 2006 fiscal period, TalkTech Inc.
wrote off $5,000 (the subtraction noted above) of amounts previously expensed and included in the opening
allowance for doubtful accounts. TalkTech Inc. also ended up collecting $1,500 of previously written-off bad
debts.
In an attempt to attract a particular retail customer, TalkTech Inc. provided this new customer with an
incentive to make a large initial purchase of its products. On April 1, 2006, TalkTech Inc. sold $300,000 worth of
cellular phones to CellBlock Limited. TalkTech agreed to the following payment terms in an attempt to entice
CellBlock Limited to make the purchase:

$100,000 due and payable May 1, 2006; and

$50,000 due and payable January 1 each year starting January 1, 2007 through January 1, 2010.
The cost of the good sold under this contract was $180,000. The delivery date for the cellular phones sold
under this contract was May 1, 2006.
One of TalkTechs customers was experiencing financial trouble. As a result, TalkTech Inc. had agreed to
make shipments only if payments were received well in advance of the anticipated shipping dates. Under the
terms of this agreement, TalkTech Inc. received $40,000 from PhonesNThings on September 30, 2006. This
payment was an advance payment for a shipment of new technology cellular phones which TalkTech Inc.
expected to be shipping to customers commencing February 1, 2007. In the event that TalkTech Inc. was unable
to honour its contract with PhonesNThings, a full refund of the $40,000 was payable.
REQUIRED
(A) Prepare a schedule showing the effect of the above information on income for tax purposes of TalkTech
Inc. for the year ended October 31, 2006. From this comparison, determine any adjustments that would be
necessary to reconcile accounting income and income for tax purposes for the year.
(B) What would be the tax consequences if the $5,000 subtraction in the allowance for doubtful accounts in
2006 included an account receivable of $800 which was written off only because it has been outstanding for
more than 180 days. In fact, it has been outstanding for one year and is part of the opening allowance of $32,000.
This $800 could still be collected and there has been no serious attempt to collect it. In fact, the remainder of that
customers account is current and further sales have been made to that customer.

Introduction to Federal Income Taxation in Canada

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Solution 3

Part A
In order to fully understand the income tax implications and thus the resulting adjustments that are needed in
computing income for tax purposes, the underlying accounting for the given transactions needs to be discussed.
The following solution will address the net impact on the income statement for accounting purposes of each of
the transactions and will then compare this to the required income tax treatment of each item. The comparison of
the accounting and tax treatment will indicate any necessary adjustments. The major discussion of the tax
treatment of each item is found in the notes.
Net impact on
income statement
Warranty reserve(1)
Accounts receivable(2)
TalkTech Inc.(3)
PhonesNThings(4)

Net impact as
per Income Tax
Act

Difference (resulting
in T2 Schedule 1
Adjustment)

$(10,000)

$(17,500)

$ (7,500)

(6,000)

(6,000)

Nil

120,000

40,000

(80,000)

Notes
(1) For accounting purposes, the increase of $10,000 in the balance sheet warranty reserve (a liability account)
will be recorded on the income statement as a warranty expense for the year. The $17,500 subtraction from
the balance sheet warranty reserve will simply reduce the cash balance as it represents the actual outlays
during the year to honour warranties that were recorded in the current or previous year(s).
For tax purposes, the $10,000 increase in the warranty reserve is not an allowable deduction because it
represents a contingent amount (not an amount which is paid or payable) which is specifically denied per
paragraph 18(1)(e). The amount does not qualify for deduction under paragraph 20(1)(m.l) since it is not an
agreement for an extended warranty nor is it insured by a third party insurer. For tax purposes, the $17,500
paid during the year to honour warranty claims is fully deductible because it represents a cost of doing
business under paragraph 18(1)(a).
(2) The bad debt expense for the year will be reflected as a single amount on the income statement. However,
this expense can often be made up of a number of additions and/or subtractions to this account. The income
tax analysis of the bad debt expense on the income statement requires that each individual component of this
amount be justified in terms of the relevant provision of the Income Tax Act. For example,
the addition to the allowance for doubtful accounts (and corresponding addition to the bad debt
expense) must meet the requirements set out in paragraph 20(1)(l),
the write-off of bad debts must meet the requirements of paragraph 20(1)(p), and
the recovery of previously written off bad debts is included in income under paragraph 12(1)( l). The
final net amount for both accounting and tax purposes should be the same.
TalkTech Inc.s $7,500 addition to the allowance as a result of the year-end aging is recorded as a bad debt
expense and thus will be a deduction on the income statement. The $5,000 written off from the allowance
during the year will be a balance sheet adjustment only as it represents amounts previously included in the
allowance and thus previously deducted for accounting purposes (as bad debt expense in the previous year).
The collection of $1,500 of previously written-off bad debts will be a credit adjustment to the bad debt
expense for the year. Thus, for the year 2005, the net impact on the income statement is as follows:
Expense Bad debt expense.......................................................................................... $ (7,500)
Contra expense Collection of previously written-off bad debt................................
1,500
Net expense for the year...................................................................................................

(6,000)

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For tax purposes, the opening balance in the allowance account must be added to income as per paragraph
12(1)(d) and the closing balance in the allowance is deductible as per paragraph 20(1)(l). The $5,000 writeoff of bad debts is allowed as per paragraph 20(1)(p) and the $1,500 of recovered write-offs is income under
12(1)(l). Thus, the net impact for tax purposes is as follows:
Add opening balance per 12(1)(d)....................................................................................
Subtract closing balance per 20(1)(l)...............................................................................
Subtract bad debt write-off per 20(1)(p)...........................................................................
Add bad debt recovery per 12(1)(i)..................................................................................

32,000
(34,500)
(5,000)
1,500

Net impact for the year.....................................................................................................

(6,000)

(3) The sale to TalkTech Inc. will result in $120,000 of net income for accounting purposes ($300,000 of sales
and $180,000 of cost of goods sold). There is no accounting for reduced income due to the instalment
payment method being used.
For tax purposes, the net income for accounting purposes of $120,000 must be included in income due to
section 9 but an $80,000 reserve is allowable under paragraph 20(1)(n) to account for the amount not due.
Thus, a net profit of only $40,000 is recorded for the year ended October 31, 2006. The paragraph 20(1)( n)
reserve for amounts due later is calculated as that portion of the gross profit on the sale that relates to the
uncollected proceeds where at least some part of the proceeds are due more than two years after the date of
the original sale (April 1, 2006). The taxation year-end of TalkTech Inc. does not play a role in the
calculation of this reserve. $80,000 = $200,000/$300,000 ($300,000 $180,000)
(4) The deposit received from PhonesNThings is considered deferred revenue for accounting purposes and
will be recorded on the balance sheet only (as a liability).
For tax purposes, the $40,000 deposit received must be included in income per paragraph 12(1)(a), although
none of that amount has been earned since it is potentially refundable if the shipment of the product does not
take place. However, an offsetting reserve of $40,000 is available under paragraph 20(1)( m) because none of
the goods are going to be delivered until after the end of the taxation year. Thus, the net impact on income
for tax purposes is NIL for the year ended October 31, 2006. The reserve recognizes the fact that none of the
amount received and included in income has been earned. This process requires all amounts received to be
accounted for in income and that the full amount deducted as a reserve be justified as unearned.
Part B
The $800 amount would not be part of the amount deductible per 20(1)( p) as there is still some hope of
collecting it. Therefore, the deductible amount under paragraph 20(1)(p) for the year will be $5,000 $800 =
$4,200. However, the method described in IT-442R, paragraph 24 would suggest that a reserve for 100% of debts
outstanding more than 180 days is reasonable. Thus, a closing reserve that includes this amount could be claimed
per paragraph 20(1)(l). Thus, the closing reserve for fiscal 2006 could be increased by $800 to $35,300.
The net impact on income for tax purposes for fiscal 2006 would be the same.
Add opening balance per 12(1)(d)................................................................................ $ 32,000
Subtract amended closing balance per 20(1)(l)............................................................
(35,300)
Subtract amended bad debt write-off per 20(1)(p).......................................................
(4,200)
Add bad debt recovery per 12(1)(i)..............................................................................
1,500
Net impact for the year.................................................................................................

(6,000)

However, in 2007, the $800 will have to be added to income per paragraph 12(1)( d) as it is part of the 2006
year-end allowance. This is a different result than in Part (A) because as a bad debt written-off in fiscal 2006, the
$800 would not otherwise be taken into 2007 income unless it was recovered in 2007.

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Introduction to Federal Income Taxation in Canada

Problem 4
[ITA: 18; 19; 20(1); 147.2(1)]
You have been assigned to the audit team for B.B. JAMS Ltd., one of your significant clients. Below is the
income statement prepared by the companys accountant for the December 31, 2006 year-end.
B.B. JAMS LIMITED
INCOME STATEMENT
FOR THE YEAR ENDED DECEMBER 31, 2006
Sales............................................................................... $ 147,840,000
Cost of sales (Note (1))................................................. (119,859,000)
Gross profit....................................................................
General and administrative expenses (Notes (2)(7))....
Selling expenses (Note (8))............................................

$ 27,981,000
(12,374,000)
(9,311,000)

Income from operations.................................................


Other income (Notes (9)(10))......................................

6,296,000
16,000

Net income before income taxes..................................


Provision for income taxes.............................................

6,312,000
(2,528,000)

Net income....................................................................

3,784,000

Through various discussions with the accountant, you have been able to determine that the following
information has been recorded in the financial statements:
(1) JAMS had a number of items of inventory that did not sell well in the current year. For accounting
purposes, the accountant has recorded a reserve for inventory obsolescence. The reserve was calculated based on
the carrying value of any inventory item that had not had a sale in the last 180 days. The reserve at year-end was
$1,285,000.
(2) JAMS provides insurance for employees and paid the following amounts to Nat Insurance Company
during the year:
$2,000,000 insurance policy on the life of the
president included in insurance expense
($300 per month)................................................ $
3,600
$1,000,000 insurance policy on the life of the vicepresident marketing included in insurance
expense...................................................................
2,000
Group term life insurance for employees included in
444,000
salaries and benefits ($37,000 12 months)............
Total
$
449,600
JAMS is the beneficiary of the policies on the president and vice-president. On June 1, 2006, JAMS
renegotiated its bank debt, and due to the ever increasing responsibilities of the president, the bank required the
insurance policy on the life of the president as part of the collateral for the loan. The premiums on the policy are
equal to the net cost of pure insurance for the policy.
(3) An analysis of the professional fees for 2006 revealed the following expenses:
Legal and accounting fees related to the issuance of shares $ 29,300
Legal fees related to amending the articles of
incorporation................................................................
2,300
Costs incurred regarding the renegotiating of the bank
loans.............................................................................
46,100
Costs incurred to defend the company against a wrongful
dismissal charge...........................................................
59,600
Costs related to the structuring of an agreement for the
purchase of equipment from a foreign company..........
38,700
Appraisal costs to determine value of the equipment for
the bank........................................................................
5,100

Solutions to Chapter 4 Assignment Problems

67

(4) During the year, there were substantial repairs completed to the outside of the building. After the repairs
some of the landscaping had to be redone. The total costs were $139,000. Of this, $23,500 relates to the
landscaping costs. The entire $139,000 was included in general and administrative expenses.
(5) A review of the other expense accounts included in general and administrative expenses showed the
following:
Depreciation and amortization......................................... $ 4,560,000
Interest on late payment of municipal taxes....................
900
Severance payments to four managers*...........................
245,000
Loss from theft by accounting clerk................................
4,500
Donations to various registered charities.........................
57,000
* All of the amounts were paid in the year.
(6) The salaries and benefits account shows contributions for certain employees to the companys
registered pension plan. The contributions were not actually made until March 31, 2007. The pension plan is a
defined contribution (money purchase) plan. The company matches the employees contributions on a dollar for
dollar basis.
Registered
Employment
pension plan
compensatio
n
President........................................ $
12,750 $
250,000
Vice-president................................
9,750
150,000
Accountant.....................................
5,400
70,000
(7) In early November 2006, JAMS announced an early retirement package that was made available to
employees over the age of 60. In order to provide employees with the time required to assess the offer, the
deadline for accepting the package has been set at February 15, 2007. While no formal replies were received as
of December 31, 2006, the personnel manager anticipates a high acceptance rate. She expects that the costs
associated with the packages will be $672,000. This cost has been accrued in the 2006 financial statements.
(8) The following information was taken from the various selling expense accounts:
Cost of sponsoring presentations at a local theatre
company................................................................... $ 15,000
Hockey game tickets given to customers.....................
8,000
Meals and entertainment costs of salespeople.............
109,500
Staff Christmas party and summer barbecue...............
43,800
Cost of sponsoring local little league teams.................
5,000
Memberships for salespeople at local golf courses......
12,700
(9) The other income includes a loss on the sale of various fixed assets of $35,900.
(10) During the year, the company had cash on hand for a short period of time due to the timing of certain
contract payments. The funds earned interest income of $10,400 while they were held.
Other Information:
(11) The accountant has calculated that JAMS is entitled to claim capital cost allowance and CECA of
$5,835,000 in 2006. You have confirmed that this calculation is correct.
(12) In reviewing the income tax assessments, you noted that JAMS had been charged interest of $4,900 on
the late payment of instalments. You discussed this with the accountant and determined that the interest was
recorded in the income tax expense account.
REQUIRED
Based on the information that you have obtained, calculate the business income for JAMS for December 31,
2006. Show all calculations whether or not they seem relevant to the final answer. Comment on all items omitted
from the calculation.

Introduction to Federal Income Taxation in Canada

68
Solution 4

Note to instructors: Reference to Schedule 1 of the T2 corporate tax return may be helpful in completing
reconciliation problems.
Net income per financial statements.................................................................. $ 3,784,000 Sec. 9
Add:
Provision for income taxes................................................. $ 2,528,000
Par. 18(1)(e)
Charitable donations...........................................................
57,000
Par. 18(1)(a)
(1)
Over contributions to company pension plan ...................
7,000
Ssec. 147.2(1)
Loss on disposable of depreciable assets............................
35,900
Par. 18(1)(b)
Depreciation and amortization............................................
4,560,000
Par. 18(1)(b)
Club dues............................................................................
12,700
Par. 18(1)(l)
54,750
Sec. 67.1
Meals and entertainment ($109,500 50%).......................
Hockey tickets ($8,000 50%)..........................................

4,000

Sec. 67.1

Non-deductible life insurance Vice-president...............

2,000

Par. 18(1)(a)

1,500

Par. 18(1)(a)

President ($300 5
months).........................
Legal and accounting expenses re issuance of shares
(80% $29,300)..........................................................
Legal expenses re articles of incorporation.........................
Costs re bank loan (80% $46,100)...................................
Costs re equipment purchase..............................................
Appraisal cost for bank (80% $5,100).............................
Accrued early retirement payments (2)..................................
Total additions....................................................................
Subtotal.......................................................................
Deduct:
Capital cost allowance........................................................
Income from business................................................................

Par. 20(1)(e)
23,440
2,300
36,880

Par. 18(1)(b)
Par. 20(1)(e)

38,700
4,080

Par. 18(1)(b)
Par. 20(1)(e)

672,000

Par. 18(1)(e)
8,040,250
$11,824,250
$ 5,835,000
$ 5,989,250

Par. 18(1)(b)

Items not Included in Computation:


1. The reserve for inventory obsolescence, although called a reserve, is deductible since the amount is
determined by identifying specific items that are obsolete and, therefore, is not a reserve or contingent liability
[par. 18(1)(e)].
2. Group term life insurance is deductible as part of the remuneration provided to employees and meets
the incurred to earn income test in par. 18(1)(a).
3. The life insurance premiums on the president are deductible after June 1, 2006 since the insurance was
held as collateral by the bank [par. 20(1)(e.2)].
4. The costs related to the wrongful dismissal charge are deductible as a cost of doing business [par. 18(1)
(a)].
5. The repairs to the outside of the building are deductible as a cost of doing business as long as they are
not enhancing the value of the building [pars. 18(1)(a), (b)] and the costs of landscaping are specifically allowed
[par. 20(1)(aa))].
6. The interest on the municipal taxes is a cost of doing business [par. 18(1)(a)].
7. The severance payments are deductible as a cost of doing business [par. 18(1)(a)].
8. Theft by an employee is an inherent risk for most businesses and as such the theft usually is a
deductible business expense [IT-185R par. 2 and Cassidys Limited v. M.N.R., 89 DTC 686 (T.C.C.)].
9. Sponsoring of the local theatre company and sponsoring of the little league teams are deductible as a
cost of doing business [par. 18(1)(a)] as long as they are reasonable in the circumstances. [See No. 577 v. M.N.R.,
58 DTC 307 (T.A.B.), and No. 601 v. M.N.R., 55 DTC 128 (T.A.B.).]

Solutions to Chapter 4 Assignment Problems

69

10. The costs of the staff Christmas party and summer barbeque is exempt from the 50% limitation for
meals and entertainment [par. 67.1 (2)(e)], to the extent that these occasional events do not exceed six times in a
year.
11. The interest earned on the cash on hand is considered business income if the income is incidental to the
business. The funds were only held for a short time and related to payments on contracts [sec. 9].
12. The interest and penalties on the income tax instalments is not a deductible expense [par. 18(1)(t)].
However, the expense has been recorded as part of income tax expense. Therefore, it has already been added
back to income as part of the income tax expense addback. No further adjustment is required.
NOTES TO SOLUTION
(1) RPP [par. 20(1)(q) and ssec. 147.2(1)]
President
Vice-President
Accountant
Least of:
(a) Employer plus employee RPP contributions.................... $ 25,500 $ 19,500
$ 10,800
(b) Money-purchase limit for 2006........................................
19,000
19,000
19,000
(c) 18% of compensation.......................................................
45,000
27,000
12,600
Least amount.........................................................................
19,000
19,000
10,800
Less: employee and employer contributions.................................
25,500
19,500
10,800
Amount to be added back (excess of actual over deductible)
6,500
500
Nil
(2) Generally accepted accounting principles require the accrual of the expected payments under the early
retirement package if the probability of the payment is likely and the amount can reasonably be estimated [CICA
Handbook Section 3290]. A reserve for a contingent liability is disallowed for tax purposes [par. 18(1)(e)]. The
deduction will be allowed for tax purposes when there is a legal obligation to pay the amount under the package.

Introduction to Federal Income Taxation in Canada

70
Problem 5

[ITA: Subdivisions a and b]


Coco Hardy is an apprentice with Sepp, a design house in Toronto. In her spare time, during some evenings
and on weekends, she operates a sewing service for clothing manufacturers. She has set aside a spare room in her
apartment where she keeps her equipment and materials and performs her services. This room occupies
approximately 20% of her apartment. She sews for many of the same companies that deal with her employer,
Sepp. The demands of her employment with Sepp will continue to prohibit her from expanding her sewing
services. Consequently, she has not advertised for additional sewing work. Her sewing billings average
approximately $600 per month.
She and the manufacturers mutually agree upon what type of sewing is to be done in order to meet the
manufacturers production deadlines. Her hourly rates are determined by the type of sewing required for a
particular manufacturer. At the end of each month, she will issue a bill to the manufacturers bearing her name,
home address, and home telephone number. Her clients pay her the gross amount on the invoice which does not
include GST.
Ms. Hardy has incurred some direct sewing expenses and has allocated some of her other costs to her sewing
services in respect of the past year as follows:
Direct expenses:
Sewing supplies............................................................................................ $ 2,890
Meals and entertainment for manufacturers..................................................
500
Sewing machine repairs................................................................................
425
Long distance telephone calls to manufacturers...........................................
710
Delivery of finished product.........................................................................
1,500
Total direct expenses..................................................................................... $ 6,025
Allocated costs:
Rent ($1,000 per month)...................................................... $12,000
Utilities................................................................................
2,100
Insurance.............................................................................
400
$14,500
Allocation to sewing room................................................... 20% $ 2,900
Capital cost allowance:
Sewing room furniture................................................. $ 450
Sewing machine...........................................................
325
Automobile for deliveries............................................
1,200
Total allocated costs......................................................................................
Total..............................................................................................................

$ 1,975
$ 4,875
$10,900

REQUIRED
(A) Discuss the issues involved in determining whether Ms. Hardy is earning employment income or
business income from her sewing service and then reach a conclusion based on the facts.
(B) Compute both income from employment and business, and comment on whether the listed expenses
and allocated costs are deductible for income tax purposes under each alternative.

Solutions to Chapter 4 Assignment Problems

71

Solution 5
(A)
Coco Hardys sewing service would appear to generate business income and not employment income. The
characteristics noted below would suggest that she is not an employee.
The Economic Reality and Entrepreneur Test
(a) The Control Test
The facts suggest that Ms. Hardy is engaged to achieve a prescribed objective and is given all the freedom
she requires to attain the desired result.
The fact that she may perform the same services as an apprentice with her employer, does not mean that the
services performed on her own time cannot be independent.
(b) Ownership of Tools/Risk Tests
Ms. Hardy owns her own tools such as the sewing machine and provides the work space. She takes at least
some financial risk in doing the sewing by incurring the direct costs.
The Integration or Organization Test
The relationships between Ms. Hardys sewing service and the various clothing manufacturers are
relationships of mutual dependency. The organization test is properly viewed from the perspective of the
individual performing the service. From the perspective of Ms. Hardy, it is her business and not that of the
clothing manufacturers. She issues billings in her own name instead of being part of the payroll or benefits
programs of the clothing manufacturers. She performs the work on her own time instead of having fixed hours
determined for her. She is free to work for others and has many customers. She can decide what is required and
how to do the work.
The Specific Result Test
Ms. Hardy has agreed to perform a specific task for each particular clothing manufacturer instead of
agreeing to be at their disposal on an ongoing basis.
(B)
Income from business for one year, assuming a reasonable expectation of profit:
Billings ($600 per month 12)..................................................................................................

$ 7,200

Direct expenses [$6,025 - (50% of $500)].................................................................................


Allocated costs (excluding home office)...................................................................................
Loss from business before home office costs............................................................................

(5,775)
(1,975)
$ (550)

The CRAs IT-514, paragraph 4 implies that a deduction for capital cost allowance on office furniture is not
limited by subsection 18(12).
Home office expenses from this year (allocated costs other than capital cost allowance) are, in effect,
available for indefinite carryforward:
Rent ($1,000 per month)......................................................................................... $ 12,000
Utilities...................................................................................................................
2,100
Insurance.................................................................................................................
400
$ 14,500
Allocation to sewing room......................................................................................
20% $ 2,900
Comments:
(1) All of the expenses listed (with the exception of 50% of the meal and entertainment expenses) should be
deductible on the basis that they were incurred to earn business income as long as an argument can be made that
Ms. Hardy has a reasonable expectation of profit.
While an expenditure need not actually result in income in a particular instance, there must be a
reasonable expectation that the business will be profitable within a reasonable time.
Ms. Hardy is presently operating at capacity and has no business plan to show how increased billings
could be achieved. Without a plan to increase her work volume or her hourly rate, she must be
expecting to continue incurring a loss for the foreseeable future. Ms. Hardy does not appear to have a

72

Introduction to Federal Income Taxation in Canada

reasonable expectation of profit. Thus, her excess expenses and allocated costs are not deductible for
income tax purposes.
Consequently, the excess expenses and allocated costs will be considered to be personal or living
expenses as defined in subsection 248(1). Paragraph 18(1)(h) will deny a deduction for such amounts.
However, the capital cost allowance of $1,975 may be deductible even if it creates a business loss. The
preamble to subsection 20(1) includes the phrase notwithstanding paragraphs 18(1)(a), (b) and (h) ...
This may indicate that a deduction for capital cost allowance in subsection 20(1) overrides the limitation in
paragraph 18(1)(h).
(2) Home office expenses, as part of the determination of income from business, must also meet the
conditions set out in subsection 18(12). Had there been a reasonable expectation of profit, the home office
expenses should have been deductible [spar. 18(12)(a)(i)] as the home office is Ms. Hardys principal place of
business, but would have been required to be carried forward as they would have increased a loss. Based on the
wording in paragraph 18(12)(c), the $2,900 of home office expenses should have been available for indefinite
carryforward.
(3) It was determined in this problem that Ms. Hardy was earning business income. However, had she
incurred the same expenses and allocated costs as part of her employment and had been required by the terms of
her employment to maintain an office in her home, the impact on employment income would have been as
follows:
Employment income ($600 12)................................................................................................ $ 7,200
Deductions:
Sewing supplies [spar. 8(1)(i)(iii)].....................................................................
Delivery [pars. 8(1)(h), (h.1)]............................................................................
Automobile (CCA) [par. 8(1)(j)].......................................................................
Income before home office expenses
Less: home office expenses per ssec. 18(13):
Rent [spar. 8(1)(i)(ii)]........................................................................................
Utilities [spar. 8(1)(i)(iii), IT-352R2].................................................................
Insurance [IT-352R2, par. 6]..............................................................................

$ 2,890
1,500
1,200

5,590
$ 1,610

$ 12,000
2,100
Nil
$ 14,100
20%

2,820

Employment income....................................................................................................................

Nil

Allocation to sewing room........................................................................................

The excess home office expenses of $1,210 (i.e., $2,820 - $1,610) would be available for carryforward
[par. 8(13)(c)].
Presumably, the employer would reimburse the employee for other costs such as the meals and
entertainment of $500, the long distance telephone calls to manufacturers of $710, and the sewing machine
repairs of $425.

Solutions to Chapter 4 Assignment Problems

73

Problem 6
[ITA: 8(1)(f), (h), (h.1), (i), (j), (3); 18-20]
Mr. Peter Rajagopal, who is a salesman in Regina, Saskatchewan, has incurred the following expenses in
connection with his employment in 2006. He was not reimbursed and did not receive an allowance in respect of
any of these expenses. Peter has a form T2200, signed by his employer, attesting to all of these expenses.
(1) Peter uses one room in his home exclusively as a home office. He uses his home office most days and
evenings to do paperwork and make phone calls and his home office computer is connected to his employers
computer system by modem. He visits his office at his employers premises approximately once a week and
spends the remainder of the time on the road, making sales calls throughout Western Canada.
(2) The following expenses relate to Peters home office which occupies 10% of the square footage of his house:
Utilities............................................................................ $ 3,100
Mortgage interest.............................................................
12,000
House insurance...............................................................
1,150
Municipal taxes................................................................
3,050
Maintenance and repairs..................................................
2,700
Total..........................................................................

$ 22,000

10% thereof..............................................................
Capital cost allowance on computer equipment ($6,900
15%)......................................................................

$2,200

Rental of photocopier......................................................
Rental of fax machine......................................................
Office supplies.................................................................
Additional monthly charges for telephone services for
family internet connection (12 $30).............................

1,035
1,200
200
750
360
1,000

Long distance calls..........................................................


(3) Peter also has the following promotional expenses:
Meals (with clients in Regina, excluding the cost of his
$ 2,100
own meals)...............................................................
Theatre tickets..................................................................
1,200
Promotional gifts..............................................................
1,300
Country club membership................................................
3,200
(4) Peter paid the following automobile expenses:
Gas & oil......................................................................... $ 2,000
Insurance.........................................................................
1,100
Licence............................................................................
90
Repairs.............................................................................
800
Cellular phone airtime charges (used for employmentrelated calls only).....................................................
700
Parking (employment related).........................................
320
Peter purchased the car that he uses for employment purposes on May 1, 2005 for $50,000 plus $3,500 GST
and $5,000 provincial sales tax. Peter did not claim CCA on the car in 2005; therefore, the capital cost allowance
rate for the car is 30% in 2006. The car was driven a total of 40,000 km in 2006; 32,000 of the kilometres driven
related to Peters employment use.
(5) Peter also incurred the following travel expenses (while away at least 12 hours):
Airfare............................................................................. $ 4,520
Meals and accommodation (including $2,400 for meals)
4,960
Registration fees for convention in Vancouver to
increase product knowledge ....................................
800

74

Introduction to Federal Income Taxation in Canada


Out-of-town entertainment..............................................

3,200

Solutions to Chapter 4 Assignment Problems


(6)

75

Interest on bank loan:


to buy the computer equipment for the home office
in (1) above
$
320
to buy the car in (4) above
800
(7) Peters remuneration from employment is as follows:
Salary............................................................................... $ 40,000
Bonus based on company sales........................................
17,000
REQUIRED
Compute the total deductible amount of expense under each of the following sets of assumptions:
(A) Peter chooses to use the following deductions as an employee:
(i) paragraphs 8(1)(h), (h.1), (l), and (j), or
(ii) paragraphs 8(1)(f), (i) and (j).
(B) Peters situation is changed to that of an independent sole proprietor.
Assume that all the amounts given are accurate, supported by receipts and reasonable in the circumstances.
Present your answer in tabular form for ease of comparison of alternatives.

76

Introduction to Federal Income Taxation in Canada

Solution 6
Notes on restriction of deductions as an employee:
Total deductible home office expenses cannot be used to create a loss from employment income
[ssec. 8(13)]. However, any excess can be carried forward against employment income, in effect,
indefinitely. This loss limitation rule will not have an effect in this particular case since total deductible
expenses do not exceed remuneration. However, one of the following conditions must be met:
(a) the home office must be the place where the individual principally performs the duties of the office
or employment, or
(b) the home office was used exclusively and on a regular and continuous basis for meeting customers
in the ordinary course of performing the duties.
Since Peter uses one room in his home exclusively as a home office, uses the office most days and
evenings, and visits his office at work only once a week, spending the rest of the time on the road, it
appears that condition (a) is met because his home office is the place where he principally performs
the duties of the office or employment. This assumes that his duties are considered to be performed
principally from his home office and not principally from either his office at work or on the road. If it
can be argued, based on the facts of the situation, that his duties are performed principally on the road,
then neither condition (a) nor (b) is met and no home office expenses are allowed.
Mortgage interest, capital cost allowance on computer and interest on loan to purchase computer are
outlays on account of capital which are not deductible in computing employment income [spar. 8(1)(f)
(v)]. Subparagraph 8(1)(f)(v) does not permit the deduction of outlays of a capital nature except as
described in paragraph 8(1)(j). The only amounts permitted under paragraph 8(1)(j) which are
applicable, in this case, are capital cost allowance and interest on a car.
Utilities and maintenance and repairs all qualify as supplies under paragraph 8(1)(i), but house
insurance and municipal taxes do not [IT-352R2, paragraph 5].
House insurance, municipal taxes, and the rental of the photocopies and fax machine are only
deductible under paragraph 8(1)(f).
Long distance telephone calls are deductible under subparagraph 8(1)(i)(iii) as supplies [IT-352R2,
par. 9(d)].
The monthly charge for the family internet connection is not deductible because it is a personal
expense. A separate phone line would be deductible under paragraph 8(1)(f).
Section 67.1 restricts the deduction for all meals and entertainment to 50% of the amount incurred. This
applies to the theatre tickets and all meals related to travelling and to entertaining clients.
Meals and entertainment (limited to 50%) and promotional gifts ($1,300) are deductible under
paragraph 8(1)(f) only. However, subsection 8(4) denies the deduction for meals unless the employee
incurs these expenses while performing his/her employment duties, for a period of not less than 12
hours, away from the municipality where his/her employers establishment is located and where he/she
ordinarily reports for work.
The country club membership ($3,200) is not deductible because paragraph 8(1)(f) does not allow the
deduction of expenses referred to in paragraph 18(1)(l).
Travelling expenses re car: because only 32,000km out of the 40,000 km driven are employmentrelated, only 80% of the car expenses are deductible with the exception of the cellular phone airtime
and parking expenditures which are 100% employment-related. These amounts are deductible under
paragraph 8(1)(h.1) or 8(1)(f), except for the cellular phone airtime which is deductible under
subparagraph 8(1)(i)(iii) as supplies per IT-352R2, paragraph 9(d).
The maximum CCA claim is restricted to the CCA on $30,000 (2005 acquisition) plus GST (7%) and
PST (10%). 80% of the CCA claim is deductible [spar. 8(1)(j)(ii)].
All of the travelling expenses are deductible under paragraph 8(1)(f), subject to the section 67.1
restriction of 50% for meals and entertainment. However, the deduction under paragraph 8(1)(h)
excludes the out-of-town entertainment.
Deductible expenses under paragraph 8(1)(f) total $18,162 but the maximum amount deductible
thereunder is limited to the $17,000 bonus based on sales. Note that Peter may still deduct amounts
under paragraphs 8(1)(i) (in respect of supplies) and 8(1)(j) (in respect of capital cost allowance and
interest) outside of this limit [IT-352R2, paras. 5 and 9]. His total claim is therefore $29,094.

Solutions to Chapter 4 Assignment Problems

77

The alternative is to deduct travel expenses under paragraph 8(1)(h) and car expenses under paragraph
8(1)(h.1) which are not limited to his $17,000 bonus based on sales rather than a deduction under
paragraph 8(1)(f). Capital cost allowance under paragraph 8(1)(j) and expenses under paragraph 8(1)(i)
would be claimed as well. Since his total claim under this alternative is $23,886, Peter is better off
making a claim under paragraphs 8(1)(f), (i) and (j).
Notes on restriction of deductions as a proprietor:
The home office restrictions in subsection 18(12) are very similar to the rules in subsection 8(13).
Home office expenses cannot be used to create a loss but any excess can be carried forward, in effect,
indefinitely. Subsection 18(12) only allows the deduction of home office expenses in the computation
of business income if one of the conditions in subparagraphs 18(12)(a)(i) or (ii) are met. These
conditions are very similar to the conditions in subparagraph 8(13)(a)(i) and (ii) as outlined above for
an employee.
The home office expenses are not restricted to deductions in section 8 therefore the mortgage
interest, the CCA on the computer and the interest on the computer loan are allowed. Peter could deduct
capital cost allowance on office portion of the house (the amount is not given in the question), but it is
not advisable since it would disqualify that portion of the house from a principal residence exemption.
(See Chapter 7.)
Subsection 20(10) allows a deduction for up to two conventions in locations which are consistent with
the territorial scope of a business.

Introduction to Federal Income Taxation in Canada

78

COMPARISON OF DEDUCTIONS
for Mr. Peter Rajagopal
Ordinary
Salesperson/Negotiators
employee
[s. 8(1)(h),
(h.1), (i), (j)]
[s. 8(1)(f)]
[s. 8(1)(i), (j)]

Proprietor

Home office:
Utilities (10% $3,100)..................................$

310(1)

Mortgage interest (10% $12,000)..............

House insurance (10% $1,150).................

Municipal taxes (10% $3,050)..................

(2)

(2)

(2)

Maint. and repairs (10% $2,700).................

$
270

310

310
1,200

115

115

305

305

270

270

CCA on computer ($6,900 15%)..................

1,035

Rental of photocopier......................................
Rental of fax machine.....................................
Office supplies................................................
Interest on computer loan................................
Telephone:
Internet............................................................
Long distance calls..........................................
Promotional expenses:

1,200
200

1,200
200
750
320

1,000

1,000

1,000

Meals (with clients) (50% $2,100)...............

1,050

1,050

Theatre (50% $1,200)..................................

600

600

Promotional gifts.............................................
Country club membership...............................
Automobile expenses:

1,300

1,300

750

750

Gas & oil (.8 $2,000)...................................

1,600

1,600

1,600

Insurance (.8 $1,100)...................................

880

880

880

Licence (.8 $90)...........................................

72

72

72

Repairs (.8 $800)..........................................

640

640

640

Cellular phone airtime.....................................


Parking............................................................
CCA on car(3)...................................................

700
320
8,424

320

700

8,424

700
320
7,920

640

640

640

Interest on loan (.8 $800) [under limit


of $300/mo.]....................................................
Other travel expenses:
Airfare.............................................................
Accommodation ($4,560 $2,000).................
Meals (50% $2,400).....................................
Convention (excl. meals)................................
Meals and entertainment ($3,200 50%).......
Total........................................................................$
Limit.......................................................................
Deduction(5).............................................................$

4,520
2,560
1,200

23,886
none
23,886

4,520
2,560
1,200

4,520
2,560
1,200

1,600

800(4)
1,600

18,162
$
17,000
$29,094

12,094
none

$
$

33,107
none
33,107

Solutions to Chapter 4 Assignment Problems

79

80

Introduction to Federal Income Taxation in Canada

NOTES TO SOLUTION
(1) Deductible [spar. 8(1)(l)(iii)], as explained in IT-352R2, par. 5.
(2) Based on the case of Felton v. M.N.R., 89 DTC 233 (T.C.C.), and concurred with in The Queen v.
Thompson, 89 DTC 5439 (F.C.T.D.), mortgage interest, municipal taxes, and house insurance are not deductible
by an employee as office rent under subparagraph 8(1)(i)(ii). (See also IT-352R2, paragraph 6, which indicates
that taxes and insurance are deductible under paragraph 8(1)(f)).
(3) For an employee, the CCA would be $8,424 (32k/40k $30,000 1.17 30%). Peter would receive a
GST rebate in 2007 for all his deductible expenses except the car CCA and car insurance with an offsetting
income inclusion of 6.5/106.5 of the same amount (assuming an average GST rate of 6.5% in 2006, under a May
2, 2006 federal budget proposal that was legislated, effective July 1, 2006). As a sole proprietor and a GST
registrant, he would receive an ITC for all his expenses except the CCA and car insurance. The CCA would be
$7,920 (32k/40k $30,000 1.10 30%).
Capital cost allowance and interest on car, deductible under paragraph 8(1)(j), and certain office costs and
supplies deductible under paragraph 8(1)(i), (IT-352R2, pars. 5 and 9) are not restricted by the amount of
commission income. The restriction applies only to amounts deductible under paragraph 8(1)(f).
(4) Note that the provisions in sections 18, 19 and 20 pertain to expenditures including convention
expenses deductible from income from business. However, the deduction of such expenditures is far more
restricted in subsection 8(1) and, while convention expenses are allowed by subsection 20(10), convention
expenses would not be allowed by any of paragraphs 8(1)(f),(h),(h.1), or (i). Note that only 50% of the cost of
meals consumed at a convention is deductible, where the cost of meals is known; otherwise 50% of $50 or (i.e.,
$25) per day is deductible.
(5) Neither of the deduction limits in subsection 8(13) or subsection 18(12) applies in this case, because
there will not be an employment or a business loss.

Solutions to Chapter 4 Assignment Problems

81

Problem 7
[ITA: 37; ITR: 2900(2)(3); 2903]
Joes Widget Manufacturers Inc. (JWMI) is an established manufacturing company with a growing research
and development (R&D) department. JWMI is a Canadian-controlled private corporation with no associated
companies. The research part of the business is new and the companys accountant has no experience dealing
with the tax implications of the expenditures in this area. He has correctly computed the companys net income
for tax purposes before specific R&D related adjustments as $615,000 and would like your input on the impact of
the transactions described below.
For the year ended December 31, 2006, the following R&D related expenditures were made.
Description
Amount
Purchase of lab machinery and lab equipment. . . $ 450,000
Purchase of building to house laboratory...........
120,000
Salaries of lab staff.............................................
100,000
Operating costs directly related to the lab...........
40,000
The lab machinery, equipment and building are used 100% for R&D activities. The lab machinery and
equipment have been capitalized for accounting purposes and are being amortized over an eight-year period (net
of available investment tax credits as set out below). Thus, amortization expense of $36,562 was recorded for
accounting purposes on the lab machinery and equipment. Depreciation expense of $4,800 was recorded on the
building.
The company is eligible for investment tax credits at a rate of 35% and has correctly determined that they
are eligible for investment tax credits at this rate on all of the above expenditures with the exception of the
building. No investment tax credit is allowable on the purchase price of the building. For accounting purposes,
the companys accountant has netted the investment tax credits against the related expenditures as follows.
Amount recorded
Expenditure
Gross amount
ITC
for accounting
purposes
Lab machinery and
equipment......................... $
450,000 $ 157,500 $
292,500
Building............................
120,000
0
120,000
Salaries of lab staff...........
100,000
35,000
65,000
Operating costs of lab.......
40,000
14,000
26,000
REQUIRED
Based on the above information, explain to JWMIs accountant the adjustments necessary in computing
income for tax purposes for the years ended December 31, 2006 and 2007.

82

Introduction to Federal Income Taxation in Canada

Solution 7
Net income for tax purposes before R&D...............................
Add:
Amount booked for salaries.............................................
Amount booked for operating costs of lab.......................
Investment tax credits on lab machinery and equipment(2)...
Investment tax credits on salaries(3)..................................
Investment tax credits on operating costs of lab(3)............
Deduct:
100% of cost of lab machinery and equipment(4).............
100% of lab salaries.........................................................
100% of lab operating costs.............................................
Net income for tax purposes....................................................

2006
615,000(1)

2007

Reference
(2)

65,000
26,000
157,500
35,000
14,000
(450,000)
(100,000)
(40,000)
$ 116,000

Pars. 37(1)(e);
& 12(1)(v)
same as above
Par. 37(1)(b)
Par. 37(1)(a)
Par. 37(1)(a)

NOTES TO SOLUTION
(1) The depreciation and amortization has already been added back in arriving at this number. CCA on the
building would have been deducted.
(2) We can only determine the impact of the year 2006 R&D expenditures on the year 2007 income, but we
do not know any further details of the income for tax purposes for the year 2007, as this is yet to be determined.
(3) In reality, a pool of R&D expenditures would be created in the year 2006 and include all of the amounts
deducted above. This pool will be reduced to Nil to the extent that all of the year 2006 eligible expenditures on
R&D are in fact claimed on the tax return. This pool will increase in 2007 by any R&D expenditures made in
that year and eligible for deduction under section 37. The balance in this pool will then be reduced in 2007 by the
investment tax credits (in total $206,500, i.e., 35% of ($450,000 + $100,000 + $40,000)) claimed in the
preceding year (2006) thus resulting in a smaller pool of available deduction in the year 2007.
(4) The building is not eligible for the 100% write-off due to the restriction in paragraph 37(8)(d).

Solutions to Chapter 4 Assignment Problems

83

Problem 8
[ITA: 9-12; 18-20; 37; 67.1; 78; 147]
The unaudited income statement for Lomas & Sons Limited for its year ended December 31, 2006 shows
the following:
Sales............................................................
$ 795,000
Cost of sales................................................ $ 350,000
General and administrative expenses..........
225,000
Research and development expenditures....
76,700 (651,700)
Operating income........................................
Other income..............................................

$ 143,300
20,000

Net income before taxes..............................


Provision for income taxes:........................
current.............................................
future...............................................

$ 163,300

Net income after income taxes....................

$ 27,000
25,000

(52,000)
$ 111,300

The information in the following notes has already been reflected in the above income statement.
(1) Payment made by company on April 1, 2007, to a
defined contribution (money-purchase) registered
pension plan for the president of the company in
respect of current employment service, allocated to
2006 expenses by the companys accountant; in
addition, the president had $7,500 withheld from his
compensation of $74,000 for the RPP.......................... $ 7,000
(2) Increase in warranty reserve on companys product
(net of expense incurred; based on self-insurance
warranty program)........................................................
16,000
(3) Depreciation expense recorded in the financial
statements.....................................................................
30,000
(4) Landscaping costs re: factory premises......................
2,500
(5) Interest on bank loan obtained for the purpose of
purchasing common shares in Advanco Ltd., a
dividend-paying Canadian corporation........................
6,300
(6) Legal costs of arranging an agreement among
shareholders.................................................................
8,500
(7) Legal and accounting fees related to issue of shares..
12,700
(8) Interest on municipal real estate taxes paid late in
error..............................................................................
1,000
(9) Golf club membership fees........................................
2,200
(10) Donation to United Way...........................................
3,000
(11) Meals and entertainment for clients.........................
4,000
(12) Appraisal fees to determine selling price of fixed
assets............................................................................
6,200
(13) Premium on term insurance on life of president
with the corporation as beneficiary; policy was not
required to be assigned as collateral for corporate
borrowing from the bank..............................................
2,800

84

Introduction to Federal Income Taxation in Canada


(14) Management bonuses ($20,000 of the bonuses
expensed in 2006, and shown as Bonus Payable on
the Balance Sheet as at December 31, 2006 has not
been paid at the time of filing the corporate tax return
on June 30, 2007).........................................................
(15) Amortization of bond discount on bonds issued in
2001.............................................................................
(16) The company has capitalized and will amortize
over five years $90,000 of costs incurred in 2006
related to the purchase of machinery to be used for
qualifying research and development. The resultant
amortization of the net cost after the investment tax
credit was $11,700 and is included in the income
statement deduction for research and development
expenditures. As well, the company incurred current
research and development expenditures of $100,000.
These current expenditures will qualify the company
for an investment tax credit of $35,000. The $35,000
has been deducted from the expenditure on SR&ED,
as shown in the income statement. In the previous
year, the company made $95,000 in qualifying
SR&ED current expenditures. The company claimed
an investment tax credit of $33,250 in respect of these
current expenditures.
(17) Interest and penalties on income tax assessments,
expensed for accounting purposes................................
(18) Items included in the financial accounting
statements in arriving at the net profit:
Amount paid by an insurance company on its
business interruption insurance to compensate for
loss of profits when company was closed down for
a month during the year because of a fire.................
Dividends received.......................................................
Volume rebates and purchase discount.........................

40,000
3,400

1,250

26,800
1,700
16,000

REQUIRED
Based on the foregoing information, compute the income from business or property for tax purposes,
ignoring tax deductions in respect of depreciable capital or eligible capital property for Lomas and Sons Limited
in respect of its 2006 fiscal year. In addition, comment on all items not included in your derivation of income
from business or property.

Solutions to Chapter 4 Assignment Problems

85

Solution 8
Note that the financial statements presented in the problem are unaudited and, hence, may not follow GAAP.
Net income after taxes per income statement
$ 111,300
Add: Provision for income taxes..................................................... $ 52,000
Pars. 18(1)(e), (t)
Payment to registered pension plan in excess of $5,820 (i.e.,
(18% of $74,000) $7,500) deductible in 2006 ($7,000
Par. 20(1)(q)
$5,820)(1).......................................................................
1,180
Warranty reserve on companys product(2)...............................
16,000
Par. 18(1)(e)
Depreciation expense..............................................................
30,000
Par. 18(1)(b)
Cost of shareholder agreement (an expenditure of a capital
Par. 18(1)(b)
nature pertaining to the sale of shares by shareholders) (3)
8,500
Par. 20(1)(e)
10,160
Non-deductible issue expense (4/5 $12,700)(4).......................
Golf club membership fees......................................................
Donation to United Way (not deductible from business
income)............................................................................
Non-deductible portion of meals and entertainment (50% of
$4,000).............................................................................
Appraisal fee (an expenditure of a capital nature)...................
Life insurance premium (does not earn income).....................
Unpaid management bonuses(5)...............................................
Amortization of bond discount(6).............................................
Amortization of SR&ED machinery.......................................

2,200

2,000
6,200
2,800
20,000
3,400
11,700

Investment tax credit for SR&ED (claimed in 2005)..............

33,250

Par. 18(1)(l)
Par. 18(1)(a)

3,000

Interest and penalties...............................................................


1,250
Deduct: items not deducted in accounting statements but
deductible for tax purposes:
Capital scientific research and development expenditures (not capitalized for
tax purposes)........................................................................................................
Current SR&ED expenditure ITC (not netted against cost in 2006 for tax
purposes).............................................................................................................
Net income from business and/or property for tax purposes...............................

Sec. 67.1

203,640

(90,000)

Par. 18(1)(b)
Par. 18(1)(a)
Ssec. 78(4)
Par. 18(1)(b)
Par. 18(1)(b)
Pars. 37(1)(e),
12(1)(v)
Par. 18(1)(t)

Par. 37(1)(b)

(35,000)
$ 189,940

Items not included in computation above:


Landscaping costs deductible [par. 20(1)(aa)].
Interest on loan to buy shares deductible [par. 20(1)(c)].
Interest on property taxes deductible as incurred to earn income [par. 18(1)(a)].
Insurance proceeds to compensate for profits included [sec. 9].
Investment tax credit on SR&ED claimed in 2006 to be included in income in 2007.
Dividends received are included in income from property [par. 12(1)(j)].
Volume rebates and purchase discounts reduce the cost of goods sold as a part of normal business
operations.
NOTES TO SOLUTION
(1) The excess contribution would not be in violation of RPP registration requirements, since it was
contributed in the first 120 days of 2007 and will likely be deductible in respect of 2007.
(2) Paragraph 20(1)(m.1) permits a manufacturer to deduct prepaid insurance premiums paid to insure
against risk under extended warranties sold to customers. The reserve must be in respect of goods to be delivered
or services to be rendered under the warranty and cannot exceed the prepaid portion of the premium that was
payable to an insurer that carried on an insurance business in Canada. The reserve in this case does not qualify.
(3) The potential subsection 15(1) benefit to the shareholder is not considered in this problem.

86

Introduction to Federal Income Taxation in Canada

(4) One-fifth of legal and accounting fees deductible [par. 20(1)(e)].


(5) The amount of a bonus unpaid 180 days after the end of the employers fiscal period can only be
deducted when it is paid and not when it was incurred.
(6) A deduction for a bond discount is available within the limits of paragraph 20(1)(f) only at the earlier of
redemption or maturity of the bonds when the amount is paid. Since no amount is paid, as required by paragraphs
18(1)(f) and 20(1)(f), the amortization is like a reserve which is denied [par. 18(1)(e)] or is considered to be on
account of capital and denied [par. 18(1)(b)].

Solutions to Chapter 4 Assignment Problems

Problem 9
[ETA: 123(1); 161; 164; 169(1); 170(1)(a); 232; 236; Sched. V, Part VII]
Reconsider the facts of Problem 8.
REQUIRED
(A) Outline the general GST requirements applicable in this corporate situation.
(B) Indicate the appropriate GST treatment of the items listed in the additional information notes.

87

88

Introduction to Federal Income Taxation in Canada

Solution 9
(A) Since the corporation is carrying on business, it is engaged in a commercial activity. [ETA: ssec. 123(1)]
Therefore, the corporation is required to register and collect GST on its supplies, i.e., sales of goods, which are
taxable supplies. As a registrant, the corporation is entitled to a full input tax credit (ITC) in respect of GST
paid or payable on goods and services that it purchases for use in its commercial activity. [ETA: ssec. 169(1)] If
GST collected or collectible on its sales exceeds its ITCs, the corporation must remit the difference. On the other
hand, if ITCs exceed GST collected or collectible, a refund of the excess is available.
Since the corporations annual revenue is less than $6 million but greater than $500,000, it will be required
to file GST returns on a quarterly basis. It may, however, elect to file GST returns on a monthly basis.
The following is the appropriate GST treatment of the items listed in the income statement.

Net income according to financial accounting statements is comprised of revenues and costs (expenses).
GST would have been charged on the revenue items and GST would have been paid on the expenses.
GST charged net of ITCs from GST paid or payable must be remitted.

There are no GST implications for the provision for income taxes.
(B) The following is the appropriate GST treatment of the additional information items:
(1) Employer contributions to a registered pension plan involve a payment for an exempt supply on
which no GST is charged. [ETA: ssec. 123(1)] As a result, no ITC is available.
(2) A charge to customers for a warranty would be subject to GST which must be remitted by the
corporation collecting it. Expenses incurred under the warranty may be subject to GST which will
provide the corporation with an ITC. Increasing the reserve, by itself, will have no GST
consequences.
(3) GST paid on the purchase of depreciable property provides an ITC, as discussed in Chapter 5.
When the cost of the asset is subsequently written off through depreciation or capital cost
allowance, there are no further GST implications.
(4) Landscaping costs are incurred for goods and services which are taxable supplies. Hence, GST
would be paid in respect of these costs and an ITC would be available.
(5) Interest on a bank loan results from a financial service which is an exempt supply on which no
GST is paid. [ETA: Schedule V, Part VII]
(6) The cost of arranging a shareholder agreement may include, for example, legal fees which are
subject to GST and which would provide an ITC.
(7) Legal and accounting fees related to the issue of shares would be subject to GST. As the issue of
shares is a financial service, an ITC would not normally be available to the corporation. However,
relief is available [ETA: sec. 185], since the financial service is related to the commercial activities
of the corporation. This provision would allow the payer corporation to claim an ITC.
(8) Interest paid results from a financial service which is an exempt supply on which no GST is paid.
(9) Golf membership fees do not give rise to an ITC [ETA: par. 170(1)(a)].
(10) Donations involve a transfer of money without consideration. No GST is charged on the donation
and, hence, no ITC is available. [ETA: ssec. 123(1)]
(11) Initially, an ITC is available on the full amount of GST paid in respect of meals and entertainment.
However, the same fraction used for the disallowed deduction applied to the ITC in respect of such
expenditures is recaptured in the first reporting period of the next fiscal year. [ETA: sec. 236]
(12) Appraisal fees are charged for a service which is a taxable supply. Hence, an ITC would be
available to the payer corporation.
(13) Insurance premiums are for an exempt supply of a financial service and, hence, no ITC is
available, since no GST was paid.
(14) Amounts paid to employees as remuneration are not supplies, since these amounts are excluded
from the definition of services in subsection 123(1) of the ETA. As a result, remuneration is not
subject to GST.
(15) A bond discount is a cost incurred in respect of a financial service which is an exempt supply. No
GST is paid and, hence, no ITC is available.

Solutions to Chapter 4 Assignment Problems

89

(16) As indicated above, GST paid on the purchase of machinery provides an ITC. The capitalization of
the research and development expenses would not have any GST consequences. However, the
current research and development expenditures incurred would likely have been subject to GST. As
a result, an ITC may be claimed.
(17) Interest and penalties charged by governments are not subject to GST.
(18) Items included in financial accounting statements:
(i) Insurance premiums are paid in respect of a financial service which is an exempt supply. An
amount received from an insurance company under a policy also involves an exempt supply of
a financial service.
(ii) Dividends received involve an exempt supply of a financial service on which no GST is
collected.
(iii) Cash discounts reduce the cost of goods on which GST is paid only where the customer is
invoiced for the net amount. However, if the invoice is for the full amount and a cash discount
is subsequently taken, the cost of goods on which GST is paid is not reduced. Thus, the payer
may claim a full ITC. [ETA: sec. 161] Adjustments made to reflect changes in the
consideration payable for a supply arising from volume rebates will allow the supplier to
refund the excess GST charged, provided a credit note is issued. Thus, the payers ITC will be
reduced. [ETA: sec. 232]

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