A December 20, 2024, Tax Court of Canada case reviewed the denial of losses from two activities, a dog breeding business and the short-term rental of properties in the Okanagan region of BC. The operation had been carried on by a married couple in the taxation years 2004 to 2010.
Dog activities
The Court undertook an extensive analysis of the taxpayers’ activities breeding champion dogs to establish a reputation for their kennel and generate revenues from stud fees and sales of puppies and semen, resulting in significant losses from 1999 to 2018. The Court first discussed whether the venture had elements of a hobby or other personal pursuit, concluding that the taxpayers’ lifelong connection to dogs suggested such elements.
Although the evidence demonstrated that the taxpayers intended to earn income, their dog-breeding activities were not a source of income as they were not conducted in a commercially reasonable manner. The Court cited the following factors as particularly relevant:
- recurring large losses over many years, with almost $1 million of losses over the 20-year period, with less than $50,000 in total revenues;
- use of credit card financing rather than securing less expensive commercial loans or lines of credit;
- rudimentary budgeting processes, lacking any plan to limit costs from various dog shows or on an overall basis;
- loose management of expenses, which were generally only summarized after the end of the year for income tax filings;
- unsophisticated books and records mingled with their law practices and rental operations;
- restrictive marketing that limited sales, which was not comparable to other commercial breeders; and
- the opinion of their own expert witness that activities generating such losses over a fifteen-year period cannot be a business.
The Court ruled that these losses were properly disallowed.
Rental activities
In 2001, the taxpayers purchased a house in a recreational area that they rented on a short-term basis. In 2005, they acquired the adjacent house to expand their rental business. The Court concluded that the taxpayers intended to earn income from the properties. In reviewing the commerciality of the activity, the Court noted the following factors:
- prior to purchasing the properties, they had undertaken research that indicated that short-term rental would be more profitable than long-term rental and obtained appraisals of market rents;
- limited rentals from 2006 to 2010 were attributable to unexpected factors including a decline in the US dollar and wildfires in several of those years that reduced demand for short-term rentals;
- they discovered that significant repairs were required to the second property, and a shortage of tradespeople delayed the repairs, resulting in that property being unavailable for extended periods;
- one of the taxpayers had prior experience with rental properties;
- the taxpayers obtained short-term rental insurance, obtained assistance for property cleaning and on-site management of renter issues and maintained a guest book to obtain feedback and solicit repeat business;
- mortgage financing and the financing of the repair costs reflected businesslike operations;
- they carefully budgeted furnishing and decorating the properties, with an eye to quality and risk mitigation with extended warranties and the scotch guarding of upholstery, practices different from those applied to their personal appliances and furniture;
- they advertised the properties and monitored the practices of neighbouring rental properties;
- they revised their strategies over time, including implementing guest book suggestions, expanding advertising to online platforms (e.g. Airbnb and VRBO) and taking advantage of long-term rental opportunities; and
- subsequent years’ results showed significant profits.
As the factors reflected sufficient commerciality, the rental losses were allowed.
Statute-barred returns?
CRA had reassessed several years after the ordinary reassessment period of three years from initial assessment. The Court noted that this was permitted only if the taxpayers had made a misrepresentation attributable to carelessness, neglect, willful default, or fraud. The Court noted that this is determined on an issue-by-issue basis and not on a year-by-year basis. Any reassessment can relate only to the misrepresentation(s) in question.
The Court concluded that the taxpayers had a bona fide belief that both the dog and rental activities were sources of income, a conclusion reached with the assistance of professional tax preparers. Their difference of opinion with CRA was either not a misrepresentation or was not attributable to carelessness or neglect. Where deductibility was a question of judgement, whether in determining whether a source of income existed or whether a specific expense was properly deductible, the returns could not be reassessed. As a result, several years were largely statute-barred.
However, some expenses were clearly not related to the income earning activities. The taxpayers’ practice of accounting for expenses only after the end of the year, rather than as they were incurred, resulted in an increased risk of error. To the extent that clearly personal expenses had been claimed, this resulted from carelessness or neglect, and these expenses could therefore be disallowed after the ordinary reassessment period.
The Court identified several expenses that could therefore be disallowed in years that were otherwise statute-barred.
Ensure your business or rental activities are conducted in a commercially reasonable and well documented manner to support loss claims and avoid disallowed deductions.
