Tax Tip Thursday

Today I want to talk about excessive deductions.

One of the benefits often cited by small-business owners is the ability to write off various expenses for tax purposes.

As a side note – I really dislike the word “write off”. People use it flippantly and leave the impression that you did not have to pay for something. That is not the case at all.

A business deduction is an expense that you have paid for through the business for the purpose of earning revenue in the business.

Otherwise, the Canada Revenue Agency can deny the deduction. In some cases, they can also assess an employee or shareholder benefit, resulting in double taxation. Once, because the expense is disallowed as a deduction, and a second time when the value of the benefit becomes taxable to the shareholder or employee.

I always enjoy telling real-life stories to highlight the point, so here goes!

Story Time

This is exactly what happened in a Federal Court of Appeal case decided earlier this month.

The case involved several siblings in Ontario who operate a large company that manufactures a variety of products, that are sold throughout North America. The business is incorporated, and each sibling is a shareholder and an employee of the business.

For the taxation year, the CRA reassessed the corporation to disallow nearly $500,000 of business expenses. Of these expenses, nearly $355,000 of them related to travel expenses (including meals). In addition, the CRA reassessed each of the siblings to include various amounts relating to the non-deductible travel in their income that it deemed personal, saying each of them had received either a shareholder or employment benefit.

The amounts were significant. One sibling, the president, was reassessed to include $211,621 in his income for 2014 and $156,696 for 2015 as shareholder benefits, which represented part of the denied travel expenses paid by the corporation for himself, his wife and his mother. Similarly, another sibling, who acted as treasurer and director of human resources, had to include $237,647 and $181,737, respectively, as shareholder benefits. The third sibling’s shareholder benefits totaled nearly $27,000 over the two years under review, while the fourth’s were almost $50,000.

In tax court, the taxpayers said all travel expenses paid by the company were incurred for the purpose of gaining or producing business income, such as meeting suppliers worldwide or developing the company’s business market.

They said the travel expenses “were not of a personal nature” and should not have been included in the computation of their income. They also argued that shareholder benefits shouldn’t apply to two of the four siblings since they only owned preferred shares in the company, not common shares.

The company president’s testimony was also found to not be credible. He stated that all disallowed travel expenses paid by the company were incurred for business purposes, but he was unable to provide any reasonable explanation nor any documentary evidence to justify the deductibility of the travel expenses by the corporation.

Among the total travel expenses deducted by the company, the CRA auditor was prepared to allow approximately $200,000 of travel expenses without any other supporting documents other than credit-card statements for trips to Dubai for an annual trade show, and trips to Chicago, New York, Vancouver, San Diego and Washington.

Other travel expenses for trips to Paris, Aruba, Nassau and Mont-Tremblant were not allowed, nor were expenses paid to Sunwing Vacations, as the auditor concluded these were personal expenses paid by the corporation for the benefit of the siblings and various other family members.

Other disallowed travel expenses included: credit-card charges incurred in Sint Maarten, including various restaurant meals; expenses at the Fairmont Tremblant in Quebec, Ritz-Carlton in Aruba and Ritz-Carlton in Grand Cayman; and some expenses incurred by a sibling’s spouse at Holt Renfrew in Montreal.

To justify any of the disallowed travel expenses, the judge said “it would have been reasonable to expect that some supporting documentation — namely emails, invitations to meetings, agendas of meetings, etc. — would have been adduced at the hearing indicating the purposes of the various travel expenses.”

Without such evidence or documentation, the judge concluded the expenses were simply not deductible and the personal expenses were included in each of the sibling’s incomes as either shareholder or employee benefits.

The siblings and corporation appealed the lower court decision, and a new trial was held at the Federal Court of Appeal on June 17, 2024. In a short, six-page decision delivered orally from the bench, the three-judge panel of the appellate court unanimously upheld the lower court’s decision.

The panel said the tax court judge properly weighed the evidence before her, noting the “total absence of documentary evidence” to back up the taxpayers’ claims that expenses were incurred for the purpose of earning business income.

The panel also addressed the argument of two siblings who held only preferred shares and felt they could not be assessed as shareholders in this case. The panel noted, however, that the Tax Act “does not make a distinction between common shareholders and preferred shareholders” when assessing shareholder benefits.

As a result, “There is… no matter here to intervene,” the panel said.

The important thing to learn from this is that the expenses need to be for the purpose of earning income and they must be supportable with documentation.

What does that mean for my business?

This means that you can’t just deduct whatever you want for your business. Just because you can tell the CRA that something should be deducted doesn’t mean it’s correct and that you should. If in doubt, ask a professional. Yes, accountants cost money to hire. But, nine times out of ten, they will save you more than they cost. Just read the above story again. If that family had spent a little bit of money hiring an accountant to tell them if their plan would work, they would not have ended up owing tens of thousands of dollars in taxes and penalties.

Save yourself the risk and the hassle, book an appointment today!

Disclaimer:

This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal or tax advice nor can it or should it be relied upon. All tax situations are specific to each individual. If you have specific tax questions you should book an appointment for a 1 on 1 consultation.