Generally accepted accounting principles and the income tax act

The question about the use of generally accepted accounting principles (GAAP) in the determination of income for tax purposes under the Income Tax Act has been subject to an ongoing debate for years. The recent Supreme Court of Canada decision in The Queen v. Friedberg [1993] 2 C.T.C. 306 provides some more guidelines in this area.

The Court has stated that GAAP will not be applied if the Court decides that the income determined under GAAP does not reflect “true” income for income tax purposes. The specific facts in this judgment relate to the principles that unrealized profits are not recognized for tax purposes until the period in which realization of the profit occurs, regardless of the treatment of such profits under GAAP.

The Crown argued for a method of determining income which, in its view, provided a truer picture of the taxpayer’s financial position at year end. At trial, the Court said that a taxpayer is free to adopt any accounting method that is in accordance with GAAP, absent an expressed provision to the contrary in the Income Tax Act. The Court of Appeal agreed with the trial Judge and the Supreme Court of Canada dismissed the Crown’s Appeal thereby accepting the taxpayer’s position.

With respect to the issue of the right of the taxpayer to choose between 2 accounting methods, both of which were acceptable under GAAP, the Court did not find it necessary to decide whether the taxpayer was required to follow the accounting method that produced the better picture of his income because it held that that method was not an appropriate measure of income for tax purposes. The conclusion is therefore that if there are 2 methods acceptable under GAAP but one method is not appropriate at all for tax purposes, then it is not a question of choosing between 2 acceptable methods, because only one method is appropriate for income tax purposes. If, however, there are 2 methods acceptable under GAAP and both methods are otherwise appropriate for tax purposes, it appears that the Court will prefer the method that produces the better picture of income. This latter statement is the implication of another case, the Court of Appeal judgment in West Kootenay Power and Light Company Limited v. The Queen [1992] 1 C.T.C. 15. The Friedberg decision reaffirms the standard view that the determination of income is a question of law and that the Court is not bound to accept an accounting method that does not, in its view, produce an appropriate measure of income for income tax purposes, regardless of the acceptability of the methods under GAAP.

Court Rules Against Revenue Canada

One of Revenue Canada’s big hammers, the “reasonable expectation of profit” test, has been struck down by the Court insofar as broad application is concerned. The Federal Court of Appeal in the recent decision of Tonn et al v. The Queen has clearly indicated that in a normal commercial venture the reasonable expectation of profit test is inapplicable. The Tonn decision involved real estate purchased for rental income and possible capital appreciation. It was not acquired for any personal use.

Restrictions on Test

The Court said that the reasonable expectation of profit test should not be used where the activity lacks any element of personal benefit and where the activity cannot be classified as a hobby. In other words, where the activity is operated in a commercial fashion and not as a veiled form of personal recreation the test is inapplicable. The Court said “…when circum-stances do not admit of any suspicions that a business loss was made for a personal or non-business motive, the test should be applied sparingly and with a latitude favouring the taxpayer, whose business judgement may have been less than competent.”

Hobby and Personal Benefits

It is important to realize that the reasonable expectation of profit test is not completely dead. In cases where the business has an element of hobby or personal benefit, the Court is saying that Revenue Canada may still apply the test.

Hobby and personal benefits cases include horse farms, Hawaii and Florida condominium rentals, ski chalet rentals, yacht operations, dog kennel operations and similar types of endeavours. These are all cases where the taxpayer has invested money into an activity from which the taxpayer derives personal satisfaction or psycho-logical benefit.

Tax-Motivated Transactions

The other area in which the reasonable expectation of profit test may still be applicable is where there are “inappropriate reductions in tax”. An example of this given by the Judge is where a commercial enterprise is operated at a loss in order to generate tax refunds or other such tax consequences.

It is important to note that this aspect of the judgement is not necessarily binding. The situation of a tax-motivated transaction is the Judge’s opinion of the correct rule to apply. But since a tax-motivated transaction was not before the Court of Appeal that part of the judgment would not have to be followed by a lower Court.

That is not to say that taxpayers or their advisors should ignore the opinion since it is clear that Revenue Canada will be applying the test to tax-motivated transactions. Rather, taxpayers should try not to be too aggressive and ensure that there is some business reality behind any transactions which they enter into, even if there is also some tax motivation for the transaction.

About the Author

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David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch