Is the $100,000 earnings in your business, business income or capital income? This is a question the Canada Revenue Agency (CRA) will ask if you don’t classify your income appropriately. Just like you categorize your expenses as business and personal, you need to categorize your income as business or capital. It is essential because tax treatment changes depending on the income category.
What is Business Income and Capital Income?
As per the Income Tax Act, business income is classified depending on the nature of trade, which means the type of business you do. For instance, if you own a grocery store, your income from the sale of goods is considered business income. If you are a used car dealer, the income from the sale of cars is considered business income. But if you sell your business or the land where you operate, it is considered capital income.
To put it in simple words, income from selling crops you grew on the farm is a business income, but proceeds earned from selling the farm are a capital income.
An income from a regular course of business activity is called business income. A one-off gain from the sale of capital property is considered capital income. A grocery store owner selling his car is considered capital income, whereas a used car dealer selling a vehicle is considered business income. The difference between the two is the nature of the business, which changes the income category.
While these are easy and clear classifications, business is full of complex trades, and the Canada Revenue Agency (CRA) looks into these complexities to find anomalies. It calls such transactions “adventure in the nature of trade.”
Adventure in the Nature of Trade
Real estate and investments are the most common transactions that fall into misclassification. For instance, Jacob is a house flipper who buys a house and remodels it to sell it for a profit. Now, he purchased and renovated a home with the intent to stay in it and later sold it for profit due to some financial crisis. Would this transaction be classified as capital income or business income?
Such transactions are difficult to classify for a third party like the CRA because many house flippers misclassify transactions to get a tax advantage. (we will discuss more on that later). The CRA will look at the intent, frequency, period of holding the property, the circumstances under which it is sold, and the nature of the business.
When the asset is a property, the CRA also looks at the secondary intention for buying the property. If the secondary purpose is resale for profit, the CRA classifies the sale as business income.
In our example, if the CRA concludes that Jacob’s transaction is a business income, it will be called an “adventure in the nature of trade.” It means that Jacob’s transaction is an ordinary course of business and is not a capital gain. If so happens, Jacob must declare the amount he got from selling the house as business income and pay tax on it. And if he has not saved the receipts of the expenses he incurred to remodel the home, he won’t even be able to claim the business expense.
When faced with such a situation, it is better to consider making a Voluntary Disclosure before the CRA scrutinizes your transaction.
Why is the Distinction of Income Important?
As we saw in Jacob’s case, income misclassification can bring significant tax liabilities because of the tax implications of the two incomes.
The CRA allows you to deduct business expenses from the revenue, and the business income is taxed in full at the applicable corporate tax rate. A capital income is taxed at 50% of the capital gain at the corporate tax rate.
For instance, Jacob bought the house for $250,000, spent $50,000 renovating it and sold it for $370,000, claiming it capital income. He will only be taxed at a $35,000 capital gain. But if the CRA concludes it to be a business income, he will be taxed on $70,000 business income. Moreover, he must pay goods and service tax (GST) and harmonized sales tax (HST) on business transactions.
In the event of a loss, you can carry forward business losses (incurred after 2005) by 20 years and backwards by three years and reduce your business income. Similarly, you can carry forward capital losses for an indefinite period and backwards by three years to reduce your capital loss. As business income is recurring, a business owner would prefer to report business loss over capital loss.
The way the two incomes are taxed, any taxpayer would prefer to earn capital gains and claim business loss. Hence, it is essential to classify the income in the right bracket to do tax planning accordingly.
Real estate transactions are always on the CRA’s radar, given the sheer size of the transaction. A misclassification of a real estate property could bring in thousands and, in some cases, millions in tax revenue to the CRA. Another complicated asset is stocks and investments. Here again, you can do a voluntary disclosure if the frequent buying and selling of investments is capital income and not business income.
A professional accountant can help you classify your income correctly and plan your tax liability using the various tax benefits the CRA offers business owners and individuals.
Contact McCay Duff LLP in Ottawa For Your Accounting and Tax Planning Needs
A skilled accountant can help you keep your accounts compliant with the CRA’s requirements, even in subjective transactions. At McCay Duff LLP, our Ottawa accountants can provide services to support your accounting function, whether you need partial or complete support. In addition, we can provide you with recommendations on planning transactions in a tax-efficient manner. To learn more about how McCay Duff LLP can provide you with accounting and taxation expertise, contact us online or by telephone at 613-236-2367.
