Farming losses can now be taken against primary income

The following article is a good news story for business owners who also operate farms that may lose money.

In the following case of Craig versus the Queen,  the taxpayer wins his appeal at the Federal Court.
What this means is that taxpayers can now have both a farm and additional business without needing the farm to make the larger income in order to qualify for all the losses.

In a landmark ruling lawyer and horse owner John Craig has won his appeal to the Federal Court to deduct more than the $8,750 currently allowed under Section 31 of Canada’s Income Tax Act.

The Minister of National Revenue had appealed the Tax Court of Canada’s ruling in favour of Craig, claiming that (a) the lower court judge applied the wrong legal tests in determining whether his farm income could be combined with his legal income and (b) if he did not apply the wrong tests, the tests were not correctly applied to the facts.

The Federal Court did not agree. In the ruling, Justice John A. Evans stated that he was “not persuaded that the Judge made any error of law in applying the somewhat more flexible and generous test in Gunn for determining the circumstances in which section 31 permits farming and non-farming income to be combined so that farming is a taxpayer’s chief source of income.”

John Craig is a lawyer in Toronto whose primary income is from his law practice. Mr. Craig is also an enthusiastic standard bred owner with a business comprised of the buying, selling, breeding, and racing of standard bred horses. Mr. Craig deducted losses from that standard bred business in the taxation years 2000 and 2001 against his income generated as a lawyer.

The Minister of National Revenue (“Minister”) restricted the losses deducted by Mr. Craig to $8,750 for each year relying on Section 31(1) of the Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), which maintains as follows:
31. (1) Where a taxpayer’s chief source of income for a taxation year is neither farming nor a combination of farming and some other source of income, for the purposes of sections 3 and 111 the taxpayer’s loss, if any, for the year from all farming businesses carried on by the taxpayer shall be deemed to be the total of
(a) the lesser of
(i) the amount by which the total of the taxpayer’s losses for the year, determined without reference to this section and before making any deduction under section 37 or 37.1, from all farming businesses carried on by the taxpayer exceeds the total of the taxpayer’s incomes for the year, so determined from all such businesses, and
(ii) $2,500 plus the lesser of
(A) 1/2 of the amount by which the amount determined under subparagraph 31(1)(a)(i) exceeds $2,500, and
(B) $6,250, and
(b) the amount, if any, by which
(i) the amount that would be determined under subparagraph 31(1)(a)(i) if it were read as though the words “and before making any deduction under section 37 or 37.1” were deleted,
exceeds
(ii) the amount determined under subparagraph 31(1)(a)(i).
It was agreed that Mr. Craig’s horse activities constitute “farming” for the purpose of section 31 and was a business and a source of income for tax purposes. It was also clear that the horse business was a much smaller source of income than his law practice. Because of this fact, the Minister argued that Mr. Craig was caught by Section 31.

The Minister relied on the seminal decision of the Supreme Court of Canada in Moldowan v. Canada, (1978) 1 S.C.R. 480 (“Moldowan”) which held that a taxpayer could only escape from the restrictive tax treatment in section 31 if the taxpayer’s chief source of income was a combination of farming income and some other subordinate source of income. Under this interpretation, Mr. Craig clearly would be caught by Section 31.

Moldowan, decided in 1978, has been criticized by later Courts. Moldowan was attempting to make sense of the apparent nonsensical provision in Section 31(1) that states, “Where a taxpayer’s chief source of income for a taxation year is neither farming nor a combination of farming and some other source of income”, the taxpayer’s farming losses would be caught by section 31. On its face, this would mean that the limitation of section 31 would never apply and in every case, the taxpayer could deduct the full amount of farming losses. Clearly, this was not the intent of the legislature.

In Moldowan, the Supreme Court decided to insert (read in) a word into this phrase in an effort to understand it. The Supreme Court inserted the word ‘subordinate’ so that it now read “Where a taxpayer’s chief source of income for a taxation year is neither farming nor a combination of farming and some other subordinate source of income”, the horse business would be caught by the restrictions in section 31.

This interpretation of section 31 by the Supreme Court created its own problems and for the last 40 years, farmers  have been hit by section 31 restrictive loss deduction limits. If a farm did not generate more income, or at least a similar amount of income, as the taxpayer’s other businesses, the farm business was unable to escape from section 31.

In 2006, Gunn v. Canada, 2006 FCA 281, [2007] 3 F.C.R. 57 (Gunn) moved away from the Moldowan interpretation of section 31 and stated that a taxpayer’s chief source of income for a taxation year could be a combination of income from farming and some other source of income even if the income from the farm operation was less than the income from the other business. In other words, Gunn removed the word “subordinate” inserted by the Supreme Court of Canada in Moldowan. As such, it no longer mattered whether or not the farm operation had the larger income.

Gunn looked at the amount of income generated as one of several factors to determine the application of section 31 such as the amount of capital invested in the business, the time spent, the taxpayer’s ordinary mode of living, farming history, and future intentions and expectations. These other factors were always considered in previous cases but their importance had been overridden by the income issue.

The Craig decision has taken Gunn and applied it squarely to a standardbred horse business. The Tax Court allowed Mr. Craig to avoid Section 31 by combining farming and non-farming income even when the farming income was much less than the income generated by the law practice. The Court considered other factors to indicate the importance of Mr. Craig’s horse business as a chief source of income, including the time spent, capital invested, and the prominence of this business in the taxpayer’s every day activities. The Tax Court also affirmed Gunn’'s rejection of a city slicker/country farmer distinction when applying section 31 – all taxpayers are held to the same standard whether or not a taxpayer does the work or hires someone else to do it.

The Federal Court of Appeal upheld the Tax Court’s decision in Craig. This now opens the door for all farmers to claim full deduction of losses from their farming businesses against other income even where that other income is substantially greater than the horse business. They just have to qualify in the true sense of being a farmer.

Farmers still need to take care to structure themselves so as to not get caught by Section 31, which still exists and is a significant deterrent to all farming industries. In other words it has to be a real farm and not just a hobby or an investment.

For more information on Taxes go to www.taxauditsolutions.ca

Dan White

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