Recent Changes To The Tax Treatment Of The Horse Business

For those operating a horse business, the Federal tax system has imposed a barrier unique to the horse industry and other farming industries.  Unlike other Canadian business operators, many horse businesses are subject to special rules set out in section 31 of the Income Tax Act, R.S.C. 1985, c.1. (5^th Suppl.), as amended (the “Act”), that severely restrict the deductibility of losses against other sources of income.  No other industry in Canada faces this kind of barrier to the deduction of legitimate business losses.

Section 31 of the Income Tax Act – the Farm Loss Restriction

A horse business is considered a farm under s.248 of the Act:

“farming – includes tillage of the soil, livestock raising or exhibiting, maintaining of horses for racing, raising of poultry, fur farming, dairy farming, fruit growing and the keeping of bees, but does not include an office or employment under a person engaged in the business of farming”

Section 31 of the Act creates a restriction on the general ability of a farming business to deduct business losses where the losses are generated by a farming business which does not constitute a taxpayer’s chief source of income.  Section 31 allows only the first $2,500 of the farm loss, plus one-half of the loss in excess of $2,500 to a maximum of an additional $6,250, to be deducted against other income ($8,750 in total).  This limit applies whether an operator of a horse business has invested $5,000 or $500,000 in the business.

Section 31 itself makes no sense. For over 30 years until December 12, 2013, the section 31 stated, in part, the following:

31. (1) Where 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, … the taxpayer’s loss, if any, for the year from all farming businesses carried on by the taxpayer shall be deemed to be the total of

(a) the lesser of……[to a maximum loss $8,750].

A farmer will either make the majority of his income from farming (or only from farming) or he will make his income from farming and something else. This section includes every farmer so how can it be an exception to the general rule of full deductibility of losses? It can’t. So the court was forced to do some gymnastics to explain this nonsensical provision.

In 1977, a prominent Supreme Court of Canada decision, Moldowan v. The Queen [1977], 77 D.T.C. 521 (S.C.C.), attempted to interpret this nonsensical provision and identified three types of farming operations. This test is being used by Canada Revenue Agency (CRA) to present day.

1. full-time farmer – a taxpayer whose chief source of income is farming or a combination of farming and some other source of income.  Such a taxpayer’s farm operations may reasonably be expected to provide the bulk of income or the centre of work routine and are the taxpayer’s major preoccupation.   Such a farmer may deduct the full amount of the farming loss from other income in the year of the loss.  The phrase “a combination of farming and some other source of income” means that while the chief source of income is farming there are also subordinate sources of income such as employment, business or property that may be unrelated to the farming operation.
2. part-time farmer – a taxpayer whose chief source of income is neither farming nor a combination of farming and some other source of income but who still carries on a farming business as a sideline business.  Such a taxpayer must operate the farm with a reasonable expectation of profit but devotes the major part of his or her time and effort to other business or employment.   The amount of the farming loss deductible in the year by such a taxpayer is substantially restricted to a maximum of $8,750.
3. hobby farmer – a taxpayer, whose chief source of income is neither farming nor a combination of farming and some other source of income, and who carries on some farming activities but with no reasonable expectation of profit.  The whole amount of such farm losses will be disallowed as personal or living expenses.

Despite the Court’s best attempts, the section still didn’t work. Routinely, farmers that were “full-time farmers” under this definition would have a few bad years because of droughts or other issues and take a second job to keep the farm. This second job became the primary source of income for the farmer for that period and CRA would swoop in and re-label the farmer a “part-time farmer” thereby preventing the full deduction of the farming losses in those drought years. This would bankrupt the farmer. The Hansard notes from Parliamentary discussions in Ottawa repeatedly reference this blight on the farmer created by this bad law. Apart from the rhetoric, Ottawa did nothing to fix this problem despite intensive lobbying from industry groups and the recommendations of its own Standing Committees on Finance over the years. To make it worse, the amount of deduction permitted under section 31 in 50 years has grown from $5,000 to $8,750 at a time when the rate of inflation alone would make it over $50,000.

The Good News:

Recently, the Courts have stepped in again to help the racing and farming industries make sense of this onerous limitation on their industries. The Courts have removed the requirement instituted by the Moldowan case that farming income be the largest income for the business operator to avoid the section 31 restrictions on farming losses.

In 2011, the Federal Court of Appeal expanded the group of taxpayers that can avoid section 31 and claim full deduction of horse racing business losses against other income.  In Craig v. The Queen, 2011 FCA 22, the Court permitted a taxpayer, whose chief source of income was not farming, to claim full deduction of business losses from his horse racing business even though in most years, his racing business ran at a significant loss.

Mr. Craig is a lawyer in Toronto whose primary income is from his law practice. He is also an enthusiastic horse owner with a business comprised of the buying, selling, breeding, and racing of horses. Mr. Craig deducted full losses from that horse racing business against his income as a lawyer. CRA restricted those losses to $8,750 per year, relying on section 31. The Court overturned CRA’s decision and permitted the full deduction of the horse racing losses against Mr. Craig’s other income. In excluding the taxpayer’s horse business from the application of section 31, the Court looked at the following:

• time spent, capital committed, potential profitability, and the taxpayer’s ordinary mode and habit of work
• these will be looked at cumulatively to determine whether farming is more than a sideline business
• in this combination test, farming does not need to provide the bulk of a taxpayer’s income or even ever be the predominant business or work activity of the taxpayer
• the risky nature of horse racing is irrelevant to the application of section 31
• the use of a trainer and other farm managers is irrelevant to the application of section 31
• horse racing should not be viewed as a recreational diversion, more consistent with a sideline business than with an objective expectation of earning a profit – this is a cynical bias that has no place in the application of section 31

With Craig, it is now easier for a taxpayer to claim full deduction of business losses from a horse racing business.

The Crown appealed this decision to the Supreme Court of Canada and definitively lost in August of 2012. The Supreme Court used the opportunity to overrule its own decision of Moldowan. Most importantly, horseracing or farming income does not need to be a taxpayer’s primary source of income to avoid the application of section 31. As such, a taxpayer can earn most of his income from another source such as a profession, investments, real estate or another business, and still be able to deduct full losses from a secondary horse racing or farming business. Moldowan had made this almost impossible.

In summary, the Supreme Court listed the test for application of section 31 as follows:

When considering the application of section 31, the Court should take a contextual approach to the combination question. The relevant factors to consider are the capital invested in farming and the second source of income, the income from each of the two sources of income, the time spent on the two sources of income, and the taxpayer’s ordinary mode of living, farming history, and future intentions and expectations. The approach must be flexible, recognizing that not each factor need be significant. The question is whether, looking at these factors together, the taxpayer places significant emphasis on each of the farming business and other earning activity, and if so, the combination will constitute a chief source of income and avoid the loss deduction limitation of s. 31.

This is a fair and pragmatic approach to the problem. Cases will resolve depending on their individual circumstances as applied to these enunciated factors. Finally, some sense is being made of a section of the Income Tax Act that makes no sense on its face or in its application.

Now the bad news:

The Harper Government has redrafted section 31 as of December 12, 2013 so that is makes no sense, again. In short, it reads as follows:

“If 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 ………[section 31 will apply and the taxpayer will be subject to the restricted farming loss]”.  [Underlined words are new and were added by the Harper Government.]

This is bad law for a number of reasons:

1. It makes no grammatical sense and is completely redundant. If a taxpayer’s chief source of income is farming, then by definition this means that all other sources of income are lesser. Why then include a second type of taxpayer in section 31, one whose income is a combination of farming and some other source of income that is a subordinate source of income? It says exactly the same thing – they are one and the same taxpayer. The Income Tax Act is not known to repeat itself in this fashion. It is not what the original creators of section 31 intended.
2. This redrafting is a complete rebuke to the Supreme Court of Canada and the wisdom implicit in their decision in Craig. The Supreme Court of Canada tried to make sense of a nonsensical provision of the Act and did a good job of it. The Harper Government has gone back to nonsense.
3. With this amendment, section 31 will continue to put farmers out of business every time there is a drought (or transportation issue) and a farmer has to drive a truck or school bus to makes ends meet for a few years.

Where do we go from here?

1. The Harper Government amendment applies to the 2013 taxation year and on. Years prior to that would still be governed by the old section and by Craig. As such, for 2012 you can still file for full deduction based on Craig and other cases.
2. We should get rid of section 31 altogether and you need to make this an election issue.

Back in 1952, section 31 (then section 13 (1)) defined a “farming loss” as a loss from farming computed by applying the provisions of the Act respecting computation of income from a business mutatis mutandis –  meaning with the necessary changes being made. In other words, a farming loss was not a business loss. If it is not a business loss, it is a loss from a hobby. This is what has been missed in the more current versions of this section and this is why the section does not make sense any more.

Prior to 1952, the right to deduct losses from one business against a taxpayer’s chief source of income did not exist. However, an administrative practice had arisen which gave relief from this treatment to “gentleman” or part-time farmers. Fifty percent of losses incurred in part-time farming activities could be deducted against a taxpayer’s chief source of income. This practice was formalized in 1951 when the “gentleman farmer” was given a $5,000 tax deduction on his primary business income because of the farm. Farming was good and the government wanted to promote it.

In 1952, the government permitted all businesses to deduct losses against gains made in other businesses. This is the basis of our tax system today. The restricted farm loss provision was left in place and set apart the gentleman farmer for restriction on loss taking. Why? When read carefully, the section was intended to give a tax break to those farmers that had no ability or intention of making a profit with the farm – in other words, this was a benefit for “hobby farmers”. Because it was for an activity that was not a business, the restriction was left in place. This makes sense.

In the early century, the intention of the Legislature was to increase arable farm land by giving a tax break to those individuals that were farming without any reasonable expectation of profit in order to promote this expensive and important use of land for the benefit of Canada. Over the years, this original intention was forgotten and suddenly, farmers that are clearly in the business of farming were restricted in the losses they could deduct. This was never the intention of the original legislation.

Get rid of Section 31. You have the power in 2014 to make a difference in the next election. If you want this industry to flourish, you need to do something now. Inform your candidates about this issue and know their position on it before you cast your vote.

Catherine Willson is counsel at Goldman Sloan Nash & Haber LLP in Toronto (www.gsnh.com). This information deals with complex matters and may not apply to particular facts and circumstances. The information reflects laws and practices that are subject to change. For these reasons, this information should not be relied on as a substitute for specialized professional advice in connection with any particular matter.