February 2005

The Death and Rebirth of the “Reasonable Expectation of Profit” Test

Just when we thought the reasonable expectation of profit or REOP test was dead, it appears to have come back with a vengeance.

Simply put, the REOP test states that, for losses to be deductible, the business or income-producing property in question must have a reasonable expectation of profit. This test did not (until now) have statutory authority. Rather, it was an administrative test applied by the Canada Revenue Agency (“CRA”) and often, but not always, sanctioned by the courts.

In the past, the CRA has applied REOP to deny the deduction of losses generated by certain tax shelters and other tax-driven plans that it felt were abusive. In other cases, deductions would be denied where the venture had both personal and commercial elements. One example of the latter type is the highly leveraged Florida condominium property that is used in part to generate rental income and in part for personal use. Unfortunately, the test was applied in an indiscriminate manner and in circumstances where it was not warranted.

Taxpayers and their advisors were relieved to be rid of the uncertainty caused by REOP – but not for long. The Department of Finance gave notice in its spring 2003 budget that it could not live with the Supreme Court decisions from a tax-policy perspective. On October 31, 2003, Finance released draft legislation designed to deal with this issue. In effect, Finance was proposing to legislate the REOP test to give it statutory authority and thus override the recent Supreme Court decisions. Although the stated objective of the draft proposals was to clarify the existing law, it is clear that the proposals represent much more than a simple clarification. It is equally clear that the proposals do anything but provide clarity; taxpayers will be saddled with an even greater deal of uncertainty than existed prior to the decisions of the Supreme Court.

Under these proposals, any loss realized in a particular year will not be deductible against other sources of income unless, in that year, it is reasonable to expect that the taxpayer will realize a cumulative profit from that business or property over the period in which the taxpayer has carried on, and can reasonably be expected to carry on, that business or has held, and can reasonably be expected to hold, that property. Although not yet legislated, these proposals are scheduled to apply to taxation years beginning after 2004.

The following are only a few of the points that should be noted:

1. The test must be applied each year during which the business is carried on or the income-producing property is held, not just at the beginning of the venture. Consider the example of an income-producing property that, at the time of acquisition, was expected to generate a considerable amount of profit over its likely holding period (the determination of a likely holding period is an issue of its own). Losses are incurred in the first three years (as expected) and in year four, because of developments that were not expected at the time or purchase, it becomes obvious for the first time that the property will not generate cumulative profits. Although the losses in years one to three will be deductible, the losses for year four and subsequent years will not be deductible. This will be the result despite the fact that the venture was entered into purely for commercial reasons and on a financial basis that was sound at the outset.
2. What about the taxpayer who borrows money to invest in common shares? Capital gains will not be taken into account in determining expected holding period profits or losses and it therefore quite possible that low-dividend paying shares will generate holding period losses. Under these circumstances, it is clear that the proposed rules could be applied to deny the losses. The past administrative position of the CRA is that such interest would normally be deductible notwithstanding the likely losses. Finance has indicated that it does not expect any change in this administrative practice. If the policy choice is so perfectly clear, Finance should provide taxpayers with a specific exemption for common share investments.
3. The proposals contain no mechanism that would allow disallowed losses to be carried over and deducted against net profits earned in other years. While losses may be expected to exceed profits over the anticipated holding period, it could well be that profits might be realized in one or more of those years. As currently drafted, while the losses would be disallowed because of the cumulative losses expected during the holding period, the profits would be subject to tax. This is so patently unfair that it barely needs mentioning.
4. There is a complete lack of grandfathering provisions in the proposals. Taxpayers may have entered into business ventures relying on the law as it read at the time and may well have made significant long-term commitments. It would simply be wrong not to grandfather any ventures entered into, or to which the taxpayer was substantially committed, prior to October 31, 2003.

The professional tax community has suggested alternatives to these proposals, alternatives that would achieve the stated objectives of the proposals without all the collateral damage. We can only hope that these recommendations will cause Finance to rethink, if not abandon, the proposals. Given the history of these things, I do not think we should hold our collective breaths.

George F. Johnson, C.A.
Senior Tax Partner, Crawford, Smith & Swallow, LLP

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