Introduction
Not just anyone can become a farmer; yet many Canadians aspire to transfer from their existing occupation into farming. The challenge with said aspiration is that starting up a farm business is difficult, and though the federal government provides some financial incentives for farmers,[1] the process of changing occupations can be risky, fraught with difficulty and is impeded by certain elements of Canada’s taxation system, specifically that of the restricted farm loss regime.
Farm Losses
Section 111 of the Income Tax Act (Canada),[2] in combination with the definition of “farm losses” in subsection 111(8), and the definition of “farming” in subsection 248(1), enables taxpayers who are engaged in the business of farming to offset their income from their farm businesses, as well as their income from any incidental activities, with their farm losses. Additionally, farm losses may be used to offset other sources of income so long as the chief source of income of a taxpayer is generated through the business of farming.
Farmers have generally been classed into three categories. These include full-time farmers, part-time farmers and hobby farmers. Broadly speaking, farm losses are available only to full-time farmers and to part-time farmers under certain conditions. Farm losses are not available to hobby farmers at all since a hobby has been defined by the courts as a pursuit outside of one’s regular occupation that is engaged in especially for relaxation, whereas a business is defined as a commercial venture undertaken with an expectation of profit.
Restricted Farm Losses
Overview
The restricted farm loss regime in section 31 represents a carve-out of the overall farm loss rules in the Act. These rules have a potentially devastating impact upon the part-time farmer.
Where farming, together with incidental activities, represents the principal or chief source of business income, which generally speaking means more than 50 percent of all income, a taxpayer may claim farm losses realized for the year against all of their income. However, if a taxpayer’s total income is not principally from farming, such taxpayer will only be entitled to a restricted farm loss, whereby only a portion of the total farm losses will be deductible against other sources of income. Effectively, where these rules apply, if a taxpayer incurs farm losses of greater than $32,500, such taxpayer may claim a maximum farm loss deduction of $17,500 ($2,500 plus 50% of the next $30,000 of losses) which may be used to offset all other sources of income. Any excess is considered a restricted farm loss, which is only deductible against farming income. These losses can be carried back 3 years, or carried forward 10 years for losses incurred 2005 or earlier, or 20 years for losses incurred after 2005.
Judicial and Legislative History of Restricted Farm Loss Rules
In August of 2012, the Supreme Court of Canada decided in The Queen v Craig[3] that certain factors should be considered in the analysis as to whether a part-time farmer’s secondary occupational activities should trigger the restricted farm loss regime. These factors include the capital invested in farming and in the second source of income, the level of income from each of the two sources, the time spent on the two sources of income and the taxpayer’s ordinary mode of living, farming history, and future intentions and expectations. If, pursuant to such analysis, it were determined that such taxpayer placed significant emphasis on both the farming business as well as the other earning activity(ies), such that in combination they constituted a chief source of income, then the restricted farm loss rules should not be applied.
Shortly thereafter, in 2013, the legislature amended section 31, providing, “[i]f a taxpayer’s chief source of income for a taxation year is neither farming nor a combination of farming and some other source of income that is a subordinate source of income for the taxpayer, then…,”[4] and to paraphrase, such taxpayer may not deduct his or her farming losses against all other income without restriction. These amendments now required that the farming source of income must be the primary source of income in order to have the farming losses fully deductible.
Application of the Restricted Farm Loss Rules
It is no secret that the intention behind the restricted farm loss rules is to prevent hobby farmers, or individuals who engage in farming activities but who do not intend to earn business income, from deducting their losses against sources of income other than income from farming.
The purpose of this paper, however, is to illustrate that the rules capture far more than the activities of the hobby farmer. Take for example, the individual who works in a professional industry and desires to venture into the agricultural sector. The capital required to purchase or lease farm land and farming equipment is immense, and generally speaking, cannot be acquired at the outset but rather must be built up over time in piecemeal fashion. Usually, said individual would be obligated to maintain their initial occupation during the transition period since they obviously must sustain themselves during the initial stages.
Where a farming operation has not yet fully developed, there is a likelihood that it will sustain losses. According to the CRA’s audit department,[5] “the determination as to what extent losses incurred by [a] smaller, frequently one-person farming operation are deductible, is a difficult task, particularly in the early, formative years.” Unfortunately, for the transitioning part-time farmer, not only is this determination difficult for the CRA, but the early formative years happen to be the most difficult period for a new farming operation with respect to efficacy.
During its audit procedure, CRA will first determine whether or not the activities of a taxpayer constitute a commercial activity, thus giving rise to a source of income. It is at this stage that hobby farmers are eliminated from consideration. If a commercial activity is detected, the next step will be to determine whether the activity constitutes the taxpayer’s chief source of income. To this end, “farming operations must provide the majority of income or be the centre of the taxpayer’s work routine and their major preoccupation”[6] to avoid the restricted farm loss rules.
For a farm operation to be considered the chief source of income, a taxpayer must demonstrate that both the amount of time and capital that they contribute to their multiple occupations favour their farming business. CRA will examine the number of hours per week and number of years devoted to farming in comparison to other sources of income.[7] Also to be considered is the question of what the focus of the taxpayer’s routine was, and whether their schedule had been arranged to give farming the priority.[8] This consideration, given the fact that the initial occupation of the taxpayer may require him or her to work during daytime hours, with farming activities relegated to the evening, produces an unjustifiably prejudicial result.
In Closing:
To its credit, CRA accounts for the circumstances in which a taxpayer “changes his or her occupation to farming,” declaring that section 31 “does not restrict the initial losses in the first years when a taxpayer is in the process of changing occupations and leaving employment or another business to adopt farming as a chief source of income.”[9] However, the transition period is rarely so efficient that a part-time farmer who maintains a previous occupation, to some extent, is not captured by the restricted farm loss regime.
Given the factors recommended to be considered by CRA during its audit process, it would appear that its expectation is that a taxpayer who desires to venture into the agricultural sector must first be significantly financially prepared to do so, and secondly must set aside their previous occupation to great extent, immersing themselves primarily in the farming occupation. This is certainly a difficult prospect for the individual who must acquire land and machinery piece-by-piece over time, while using their initial occupation to fund the transition period; a period which can span many years.
The recommendation for those individuals who find themselves farming in a part-time capacity is that they strive to satisfy the requirements considered by CRA. Records should be kept of all of the time spent on the farming activity. Individuals should be employed by the part-time farmer, if possible, to assist in various aspects of the operation including financial and strategic planning. Non-farming capital expenditures should be reduced to a minimum. Funds earned through the individual’s other occupation should be spent on the farming operation, to the greatest extent possible, and such funds should be traceable. A clear and concise written plan and timetable should be developed by the individual, which establishes his or her plan for maintaining and developing the farm business and which strengthens and solidifies the argument that the farming business represents such individual’s chief source of income.
All things considered, it is doubtful, given the demographic landscape of the existing agricultural sector, and the growing trends as previously highlighted, that the penalizing nature of the restricted farm loss rules in section 31 will be sustained for long.
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[1] For example, in Ontario: Canada Business Ontario, Grants, Subsidies and Contributions – Agriculture, Government of Canada, online: <http://www.cbo-eco.ca/en/index.cfm/financing/government-loans-and-grants/grants-subsidies-and-contributions-agriculture/>.
[2] Income Tax Act (Canada) RSC 1985, c1 (5th Supp) (the “Act”) [Unless otherwise indicated all statutory references in this paper are to the Act.].
[3] [2012] 2 SCR 489, 2012 SCC 43.
[4] Supra note 4 at section 31.
[5] Canada Revenue Agency, Audit Manual, Chapter 29 – Losses, July 2014.
[6] Ibid at 29.4.5, Farm losses not deductible—No source of income, (Revised September 2013).
[7] Ibid at 29.4.7, Restricted farm losses, (Revised September 2013).
[8] Ibid.
[9] Ibid.
