In Brown v Canada1, the Federal Court of Appeal provided further guidance on its rephrased source of income test from its recent decision of Paletta.2 Source of income is a fundamental concept in Canadian tax law. There can be no taxation without income and, subject to specific exceptions, no income without a source. With respect to the first question of this source test – of whether there is a personal or hobby element to the activity – the Court of Appeal instructed that a personal reason for conducting an activity cannot, in and of itself, be considered a personal endeavour. This led to a finding that there was no personal element to Mr. Brown’s activity. The Court then considered the test’s second question – of whether there was a pursuit of profit (which it found to be necessary in a source of income test). The Court of Appeal found that the evidence demonstrated a pursuit of profit by Mr. Brown, and it referred the matter back to the Tax Court to determine whether the expenses claimed are deductible.
In April 2010, the taxpayer, Darrell Brown, and his wife, Lyudmila Bezpala-Brown, opened an art gallery in Toronto. Initially, the art gallery was primarily managed by Ms. Bezpala-Brown and a friend. At that time, Mr. Brown, a lawyer, provided the gallery with limited managerial and administrative-type services.
In September 2010, Ms. Bezpala-Brown became ill – then pregnant – and was no longer able to run the gallery. As a result, Mr. Brown became more involved in the gallery business and, in early 2011, he was officially retained to provide management services. The compensation paid to Mr. Brown was a management fee, equal to 20% of the amount by which the gallery’s annual revenue exceeded $100,000.
Mr. Brown provided management services to the gallery in 2011, 2012, and 2013 and, each year, the gallery failed to generate enough revenue to trigger a payment to Mr. Brown. The gallery incurred losses in each of the years at issue. Mr. Brown claimed non-capital losses of $90,696 for 2011, $115,200 for 2012 and $113,932 for 2013 (which he later conceded were overstated).
The Minister reassessed Mr. Brown to deny the non-capital losses claimed on the basis that his management services activity was not a source of income and that the amounts claimed as expenses were not reasonable.
The tax court decision
The Tax Court of Canada (“TCC”) dismissed Mr. Brown’s appeal on the grounds that he did not have a source of business income during the taxation years under appeal. The Court found that Mr. Brown’s activity had a personal element, and that the activity was not carried on in a sufficiently commercial manner to constitute a source of business.3
Through applying the source of income test in Stewart 4 and weighing the evidence, the TCC found a personal element to Mr. Brown’s activities as he only began providing management services to the gallery because of Ms. Bezpala-Brown’s health issues. The TCC also concluded – based on the evidence – that Mr. Brown’s activities were not carried on in a sufficiently commercial manner to constitute a source of business.
Mr. Brown appealed the TCC’s decision.
The federal court of appeal decision
Justice Webb of the Federal Court of Canada (“FCA”) allowed Mr. Brown’s appeal and held that the TCC erred in law in its interpretation of Stewart. More specifically, the TCC erred by focusing on Mr. Brown’s personal reasons for providing the management services to find that this activity was a personal endeavor and not a source of income. Rather, the FCA stated that the TCC should have focused on the activity itself to determine if there was a personal or hobby element.
The FCA began its analysis with reference to the test in Stewart, and then set out its rephrased approach to determining whether a person has a source of income:
Is there a personal or hobby element to the activity in question?
- If so, the next enquiry is whether “the activity is being carried out in a commercially sufficient manner to constitute a source of income”.
- If not, the next enquiry is whether the activity is being undertaken in pursuit of profit.
For the first question, the FCA explained that the focus should be on the activity itself and whether there is any personal or hobby element to the activity. The FCA also clarified that a person’s personal motivation or reason for conducting an activity cannot, in and of itself, result in there being a personal or hobby element to the activity. This is because it is possible to find a personal reason why any person is carrying on a particular activity, and this could potentially subject every activity to the reasonable expectation of profit test.
In examining Mr. Brown’s activity – the management services – the FCA found that these services allowed the gallery to continue to operate and that there is no indication that there was any personal or hobby element to the management services. The Court found that the TCC erred in finding that there was a personal element because Mr. Brown undertook his management activities as a result of his spouse’s inability to continue to manage the gallery.
The FCA then considered the second question and stated that the intention to profit is necessary in a source of income analysis. The Court clarified that this question is whether the taxpayer is pursuing profit in undertaking the actidvity in question, not whether this was his predominant intention. The FCA found that the TCC also erred by focusing on the deductions claimed by Mr. Brown because the question of whether a person is pursuing a profit is separate from the question of the deductibility of any expenses claimed.
The FCA ultimately concluded that Mr. Brown was in pursuit of profit in providing the management services because this activity was inextricably linked to the gallery business (his revenue was a percentage of the gallery’s gross revenue) and his services allowed the gallery to continue to operate until it could generate sufficient revenue to cover its expenses. The Court found that Mr. Brown’s intent was to allow the gallery to generate revenue which, in turn, would generate the management fees payable to him (i.e., profit for his management services activity).
If you have any questions regarding this decision, or the law on source of income, please reach out to our KPMG Law contacts below.
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