Preparation doesn’t pay

Can’t write off expenses related to exploring pre-business activity

When does a business become a business for tax purposes? This question is fundamental to knowing when to write off losses associated with a business activity against other income on your personal tax return.

Take the case of Patrick Walsh (Walsh v. the Queen, 2011 TCC 341), decided over the summer. Walsh claimed business losses in 2005 and 2006 of about $13,000 in each tax year.

Walsh claimed the losses ought to be deductible as they arose “in the course of the conduct of a business.” CRA maintained that the expenses incurred were “personal in nature and the asserted business activity had not yet commenced.”

Walsh was forced to retire from his chartered accountancy practice due to health issues. He tried to find a business compatible with his skills and health. In addition to his CA, Walsh holds economics, business and accounting degrees. He researched several opportunities before settling on trading forex contracts in the spot market.

In 2004, he purchased trading software and a new computer capable of supporting the “multiple and simultaneous tasks that the software permitted him to perform.” Walsh testified that in 2005 he didn’t enter into any real trades, while in 2006, he likely invested “only a few hundred dollars” in FX trading.

For those two tax years, Walsh kept proper accounting books and records and included the T2125, “Statement of business activities,” with his personal tax returns. The judge referred to Walsh as “a serious student of forecasting price movements in the currency markets using his educational background together with his understanding of the interaction amongst interest rate pressures, currency values, inflation, employment, balances of trade and like factors.””

But the issue was when Walsh actually entered into trading activity of his business. Was it as early as 2005 or 2006, which would let him claim his business losses, or was it later in 2008, when his losses started to decline?

The judge’s analysis turned primarily to the oft-cited 2002 SCC decision in Stewart, which looked at the intentions of a taxpayer when there is a “personal element” involved in a commercial activity.

A personal element does not merely include a “hobby type activity,” but may also include an “educational pursuit,” even if it is ultimately aimed at preparing the particular taxpayer for a subsequent business endeavour. The court said, “Developing the know-how to operate a specific type of business, which was the intention here, is personal development, not a commercial activity per se.”

As a result, the judge concluded that Walsh’s activities in 2005 and 2006 were not a source of income as they “did not yet reach the level of commerciality to justify a finding that a business had commenced. […] Preparations leading to creating a business activity are not themselves yet a business.”

Similar results were reached in other cases, concluding that “educating oneself as a preparation to the start-up of a business is essentially a personal activity and not a business activity.”

The judge found Walsh’s work in 2005 and 2006 was mostly geared to determining the business entry strategies, given the small amount of capital he put at risk in the years in question. Walsh admitted throughout his testimony that during these years, “he was at a pre-exploitation stage of the subject activity.” The court concluded that since the business had not commenced in 2005 and 2006, the losses from those years were not tax-deductible.

Jamie Golombek, CA, CPA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto. Jamie.Golombek@cibc.com