12 August 2009 Internal T.I. 2009-0317891I7 - Deductibility of an expense

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: What is the tax treatment follow up an acquisition of an asset which was paid but not delivered?

Position: Question of fact

Reasons: Law, General comment

										August 12, 2009

	EDMONTON TSO							HEADQUARTERS
										Income Tax Rulings
	Attention:  Mrs. Edith Keefe-MacLeod			Directorate
				Anne Dagenais
(613) 957-2121
										2009-031789

Deductibility of an expense

This is in response to your e-mail dated April 15, 2009 regarding the purchase of vending machines to earn business income. More specifically, you are asking about the tax treatment of a loss incurred on the acquisition of these machines which were paid for but not delivered. The question is not related to an audit file and no details or facts were submitted. Nonetheless, the following comments may be of assistance.

Subsection 9(1) of the Income Tax Act (the "Act") provides that a taxpayer's income from a business or property is the profit from that business or property subject to the rules in Part I of the Act. Section 18 of the Act sets out the general limitations for deductions in computing the income of taxpayer from a business. For example, paragraph 18(1)(a) of the Act denies a deduction for all outlays and expenses except to the extent that the outlays or expenses are made for the purpose of gaining or producing income from the business or property. Furthermore, paragraph 18(1)(b) of the Act denies a deduction for all outlays, losses or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by Part I.

It is the general view of the Canada Revenue Agency (the "CRA") that before an amount can be considered to have been incurred for the purpose of gaining or producing income from a business, it is also necessary to establish whether a business has in fact commenced. In most cases, expenses in respect of a proposed business that are incurred prior to the commencement of the business do not constitute a business loss or a non-capital loss and thus cannot be applied against income in the year the expenses were incurred, and cannot be carried back to be applied against income of the preceding year or forward to be applied against income of any subsequent year. After a business has commenced, all expenditures that are recognized for purposes of the Act and that are made in respect of the business are to be classified in the usual way as being expenses incurred for the purpose of earning income or as outlays on account of capital. Such a classification is always a question of fact. Information regarding whether a business has commenced can be found in Interpretation Bulletin IT-364, "Commencement of Business Operations". Generally, the CRA view is that a business commences whenever some whenever some significant activity is undertaken that is a regular part of the income-earning process in that type of business or is an essential preliminary to normal operations.

Accordingly, in the situation at hand, the first step in determining whether an amount is an amount deductible by a taxpayer is to determine whether it is an amount that is deductible as a business expense under section 9 of the Act. In other words, it is necessary to determine whether the taxpayer is, in fact, carrying on a business. Assuming the taxpayer has a source of income from a business, reasonable expenses incurred by the taxpayer in the course of carrying on that business would be deductible pursuant to subsection 18(1)(a) of the Act only if the activity is undertaken in a sufficiently commercial manner.

We have previously considered issues concerning the deductibility of losses by investors who had been victimized by fraud or a scam. In specific situations such as when no shares are purchased and no investment made in any property upon which to make a profit or to sustain a loss, the act of a person taking the taxpayer's money for personal use was not an adventure in the nature of trade on behalf of the taxpayer. However, since it was the capital itself that was stolen, the resulting loss was considered to be a capital loss at the time the theft was discovered. In those cases, the taxpayer had taken reasonable, although not successful, steps to verify the validity of the operation. On the other hand, there is the Hammill case (2004 DTC 3271 (TCC)) relating to losses incurred by a victim of a fraudulent business scheme. In this case, the taxpayer believed he was investing in a promising business opportunity by purchasing gems for resale. Instead, he lost his inventory and paid fraudulent brokerage commissions. The Tax Court found that the taxpayer could not have been involved in a business because it was objectively unreasonable to have believed that a business existed. Consequently, all expenses were denied under paragraph 18(1)(a) and section 67 of the Act.

If no business has commenced, the money could be a personal-use property of the taxpayer as defined in section 54 and any capital loss on disposition would be deemed to be nil by virtue of subparagraph 40(2)(g)(iii) of the Act.

If the business has commenced, the expenses would not be deductible in the taxation years in which they are incurred, if they were incurred on account of capital pursuant to paragraph 18(1)(b) of the Act which would be the case if they were to acquire vending machines.

In the event that paragraph 18(1)(b) of the Act precludes the deduction of the expenses, the expenses could still be deducted in the manner provided for under one or more of the paragraphs contained in subsection 20(1) of the Act. One such provision is paragraph 20(1)(b) of the Act, which provides for the deduction of expenses that can be considered eligible capital expenditures under subsection 14(5) of the Act. Where a taxpayer has ceased to carry on a business and no longer owns any property of any value that was eligible capital property of the business, the taxpayer may deduct any positive balance of cumulative eligible capital pursuant to paragraph 24(1)(a) of the Act. This final balance in the pool is referred to as a "terminal allowance" and allows the taxpayer a deduction. Please refer to Interpretation Bulletin IT-143R3, "Meaning of Eligible Capital Expenditure", IT-123R4, "Disposition of and Transactions Involving Eligible Capital" and IT-123R6, "Transactions Involving Eligible Capital Property" for more details.

Subsection 20(16) of the Act of the Act provides the authority to claim a "terminal loss" in respect of a taxpayer's depreciable property. However, the taxpayer is not entitled to include the capital cost of a property in a particular class of depreciable property that was used in the business unless the machine was "owned" by the taxpayer. In the present situation, we are of the view that if the taxpayer has not acquired any machines, the taxpayer cannot include the capital cost of that property in a particular class. Thus, there would be no terminal loss to claim because there would be no undepreciated capital cost of a particular class of depreciable property related to the property. Please refer to Interpretation Bulletin IT-285R2, "Capital Cost Allowance - General Comments" and Interpretation Bulletin IT-478R2, "Capital Cost Allowance - Recapture and Terminal Loss", for more details.

Yours truly,

Renée Shields
A/Director
Business and Partnerships Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch