Claiming Business Expenses – What’s deductible and When
Every business incurs and pays a wide variety of business-related expenses on a day-to-day basis, ranging from employee payroll to advertising costs to utilities bills to the cost of new equipment. A general rule, for tax purposes, is that all reasonable current expenses which are incurred for the purpose of earning business income are deductible from that income. Effectively, a business doesn’t pay income tax on income which has been used to pay expenses related to earning that income. While the rule regarding the deduction of business expenses can be stated in simple terms there are, within that rule, myriad exceptions, qualifications, and restrictions. Most of those are the result of provisions in our tax law that limit, in one way or another, the amount of deduction which can be taken for a particular kind or class of expenses.
Current vs. capital expenses
The first step to be taken in determining whether a business expense can be deducted from income in the year in which it is incurred is determining whether the expense is “current” or “capital” in nature. Current expenses can, in most cases, be wholly deducted from income earned in the year in which the expense is incurred. A deduction can also be claimed for capital expenses, but those must be deducted over the course of a number of years, through the tax system’s capital cost allowance (CCA) regime.
The line between current and capital expenses isn’t always a clear and distinct one, and many disputes (and much tax litigation) have taken place over the years in the determination of which side of that line a particular expense falls. The general rule is that an expense is capital in nature (and therefore cannot be deducted in its entirety from current year income) where it brings into existence an asset of enduring benefit to the taxpayer. In this context, enduring benefit is taken to mean having a useful life of more than one year.
The application of that rule, and the difference between a capital and a current expenditure generally, is most easily illustrated by example. In its guide to the computation of business income, the Canada Revenue Agency (CRA) provides a series of examples illustrating the difference between a capital and a current expense. The examples and guidelines provided by the CRA are as follows:
Where an expense is determined to be capital in nature, then it may or may not be deductible under the capital cost allowance system. In other words, not all capital expenditures are eligible for capital cost allowance treatment, and those which are not and which cannot qualify as a current expense are simply not deductible for tax purposes.
The capital cost allowance system separates assets in to a number of pools, or classes. A prescribed percentage of the cost of the assets assigned to each class can be deducted (but is not required to be—the deduction is optional) each year on the annual tax return. Such deduction is usually taken on a declining balance basis (that is, deducted from the balance remaining after the previous year’s deduction was taken), but in some cases the deduction may be made on a straight-line basis (each year’s deduction is calculated as the applicable percentage of the original cost of the assets in the class). The method to be used for each particular class is also prescribed.
One cautionary note: the rules governing the capital cost allowance system are among the most frequently amended provisions in our tax system. For instance, the CCA system is frequently used to provide assistance to particular industries by providing incentives (for example, a 100% write-off of a particular asset in the year of acquisition) to taxpayers to acquire assets produced by those industries. As well, it’s sometimes the case that the same asset could be assigned to a different class (with a different CCA rate) depending on the date on which it was acquired. Consequently, it’s important to be sure that the version of the CCA regulations which is being consulted is the current one.
Current expenses —what’s “reasonable”?
Where an expense has been determined, under the CRA guidelines, to be a current expense and therefore deductible in the year it was incurred, the next criterion which will apply is whether the expense was “reasonable”. Reasonableness is, of course, often in the eye of the beholder, and there are undoubtedly many cases in which the CRA has disallowed a deduction for expenses which are, in the taxpayer’s view, reasonable in nature. Unfortunately, it’s not really possible to provide a working definition of “reasonable” for tax purposes. There are, however, circumstances which are likely to lead the CRA to question the reasonableness of either the kind or amount of a deduction, as follows.
A final point—no matter what the kind or amount of costs or expenses claimed, it is up to the taxpayer, in all cases, to both justify the expense (in terms of it having been incurred to earn business income) and to document the cost. While receipts for business expenses claimed do not have to be filed with the annual return, the CRA has the right to ask to see those receipts. And, as with any expense claimed by a taxpayer, where the receipt or other proof of the expense cannot be produced, the CRA must assess on the basis that the expense was not incurred and the deduction will therefore be disallowed.
Once it has been determined that an expense is a current expense and the reasonableness standard is met, the next step is to determine whether the expense can be deducted in its entirety, or whether the tax system imposes limitations on either the timing or the amount of the deduction. What follows is a listing of those business expenses which are wholly deductible in the year they are incurred, followed by a listing of those to which special (usually limiting) treatment applies.
Expenses wholly deductible in the year
Bad debts
Every business runs into clients or customers who can’t or won’t pay their accounts on a timely basis or, sometimes, not at al. When a business finaly decides that an account is uncollectible and writes it off, a deduction can be claimed in the year of the write-off, assuming that the receivable had previously been declared as business income on a previous tax return.
Business tax, fees, licences, dues, memberships, and subscriptions
There are business taxes, fees, and licences which must be maintained for just about every kind of business. As well, business owners who are members of a profession or trade are likely required to maintain membership in a professional organization or trade association. All such costs, to the extent that they relate to the business, are deductible in the year they are paid. Fees paid for memberships in groups or organizations whose main purpose is related not to business but to social, recreational, or sporting activities (like a golf and country club) are not deductible at all.
Office expenses
The cost of general office expenses for goods like paper, pens, pencils, etc. which will likely be used up during the year are deductible. However, office supplies like filing cabinets, desks, etc. are considered capital purchases, the cost of which must be deducted through the capital cost allowance system and not as a current year deduction.
Supplies
Al businesses require supplies of one kind or another in order to produce the goods they sell or render the services they provide. The cost of acquiring those supplies is deductible in the year they are purchased.
Legal, accounting, and other professional fees
At one time or another, a business will usually require the services of a lawyer or an accountant, even if it is only to prepare the business’s annual tax return or to provide legal services relating to the start-up of the business. In most cases, the expense of those professional fees (including consulting fees) is deductible from income. That deduction is available as well for professional fees paid in relation to an assessment for income tax, Canada Pension Plan, Quebec Pension Plan contributions, or Employment Insurance premiums. No deduction is available, however, for legal or other fees paid in connection with the acquisition of a capital property. Instead, those fees are added to the cost of the property and claimed through the capital cost allowance system.
Insurance
Costs incurred to insure the business property (including buildings, machinery, and equipment), against loss through ordinary commercial insurance are deductible in the year they are paid.
Property taxes and rent
Whether the business premises are owned or rented by the business, property taxes or rent will be payable. Those costs are deductible, assuming that the premises and/ or property to which they relate are used in the business. Here again, special rules apply to the use of one’s home for business purposes and they are outlined below.
Maintenance and repairs
The cost of materials and labour used to effect minor repairs or do maintenance on a business property are fully deductible when incurred. Where work done on the property is more significant than minor repairs, it may be that the costs of that work must be treated as a capital expense and deducted over time under the capital cost allowance system.
Whether the cost of work done to property is current or capital in nature, no deduction is allowed for the cost or value of one’s own labour.
Salaries, wages, and benefits
The cost of salaries, wages, and benefits paid to employees often constitutes one of a business owner’s largest expenses. The gross amount of such wages and salaries are deductible from the business income. As well, the business owner can deduct the employer-paid portion of Canada Pension Plan and Quebec Pension Plan contributions and Employment Insurance premiums made on behalf of employees. No deduction is available, however, for salaries, wages, or drawings paid to the business owner.
Many businesses provide benefits to employees as part of their contract of employment. When the business pays insurance premiums for an employee for a sickness, accident, disability, or income insurance plan, the cost of those premiums is deductible in the year the payment is made.
Travel
The increased cost and difficulty of business travel as well as advances in communications technology have made travel for business purposes less frequent than it once was. Nonetheless, where travel is undertaken in order to earn business income, the cost of that travel (including public transportation fares, hotel accommodation, and meals) remains deductible from business income.
Note that a special rule, outlined below, imposes limitations on the amount of any deduction taken by the business for meals and entertainment expenses. Those limitations would also apply to such expenses incurred in the course of business travel.
Telephone and utilities
Al costs of utilities, including telephone, gas, oil, electricity, and water incurred in order to earn business income are deductible when they are paid. Special rules apply where the business premises are located in one’s home, and those rules are outlined below.
Delivery, freight, and expenses
Whether the costs are paid to Canada Post or to a private delivery or courier service, the costs of delivery, freight, and express services are deductible by the business in the year in which they are incurred.
Expenses partly deductible in year of expenditure
In some areas, the tax rules impose limitations on the deduction of expenses which would, under the general rules, be wholly deductible in the year in which they are incurred. In some cases, the amount of the deduction is limited or capped because the CRA is seeking to exclude a part of the cost which relates to personal use and enjoyment. In other cases, the tax rules require that part of the deduction be deferred to a later year to which it more properly relates.
Meals and entertainment
Where a business owner takes a client or prospective client out for lunch or dinner and picks up the tab, the cost would ordinarily be a fully deductible business expense. But, clearly, there is also an element of personal use and enjoyment of that expenditure on the part of the business owner. Strictly speaking, the best way to reflect that would be to limit the deduction to the cost of food and drink consumed by the client or prospective client and not by the business owner, such an approach is impractical, in addition to being nearly impossible to enforce. The CRA has settled, instead, on a “rough justice” approach in which the deduction available for the cost of business-related meals and entertainment is limited to the lessor of 50% of the actual cost or an amount which is reasonable in the circumstances. Practically speaking, this means that only one half of any business expenditures related to meals and entertainment may be deducted.
There is a fairly lengthy list of exceptions and qualifications to this rule, including meal and entertainment expenses relating to a special occasion party held for employees or similar expenses incurred for a fundraising event held for the benefit of a registered charity.
Prepaid expenses
It is sometimes the case that a business will pay for services or goods which are to be provided to it throughout the current year and into the next one. The example used by the CRA in its guide is that of a business which, on June 30, 2015, prepays its rent for a full year (from July 1, 2015 to June 30, 2016). In such circumstances, the rule is that one half of the rent is deductible as an expense on the business’s return for the 2015 taxation year, while the other half is deducted as an expense in 2016.
Motor vehicle expense
The rules relating to the taxation of automobile benefits expenses received by employees and the deduction of motor vehicle expenses incurred by employers are both detailed and subject to frequent revision. The general rule for businesses, however, is that where a vehicle is used for business purposes, the following types of expenses are deductible:
It’s often the case that a small business owner wil use his or her own vehicle for both personal and business-related purposes. In that situation, the business owner is required to keep records which document the use of the vehicle for business purposes, as only that portion of the motor vehicle costs will be deductible.
The types of cost which are deductible, listed above, are the same whether the vehicle is used full-time for business purposes or its use is divided between business and personal purposes. But, in either case, there are limitations placed on deductible lease costs where a vehicle is leased and on the amount of any interest payments which can be deducted where money is borrowed to purchase a vehicle. While the rules outlining those limitations can be complex, in general terms, taxpayers are entitled to claim such costs only up to a prescribed maximum set annually by the CRA.
Business use-of-home expenses— a special case
It’s always been the case that some businesses get their start as a home-based operation and grow from there. However, in recent years, the operation of a business from one’s home on a long-term basis has become quite common. In many instances, a homeowner will create a dedicated space in the home for the business and is able, with the use of communications technology, to operate the entire business from home.
Where part of a home is used for business purposes, some of the expenses related to that home become, in effect, business expenses, and may be deducted from business income.
In order to deduct such expenses, it is necessary that the business space in the home be either the principal place of business or that it be used only to earn business income and be used on a regular and ongoing basis to meet clients, customers or patients. Once either of those criteria are satisfied, the business can deduct a portion of heating, home insurance, and electricity costs, as well as a part of property taxes, mortgage interest (but not mortgage principal), and, sometimes, capital cost allowance.
To determine what portion of such costs will be deductible as business expenses, the home/business owner will need to determine what percentage of the home is used for the business. The simplest way to do so is to calculate the overall square footage of the home and square footage of the room or rooms used for business purposes. For example, if a 200 square-foot room in a 2000 square-foot house is used for the business, then the business owner would be entitled to deduct 10 percent of the eligible costs related to running the house (2000 × 10 per cent = 200).
While a claim for capital cost allowance for the portion of the house used for business purposes may be allowable, it may not be in the homeowner’s best long-term interests to make that claim. Where an owner-occupied home (a “principal residence”, in tax parlance) is sold, the gain made on that sale is, effectively, received free of tax—a benefit known as the principal residence exemption. However, if capital cost allowance is claimed on the “business” portion of the house, the part of any gain attributable to that portion will be disqualified from the principal residence exemption at the time of sale. In most cases, the cost of forgoing that portion of the principal residence exemption will be greater than the benefit which could have been received from making the available capital cost allowance claim.