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Important Supreme Court of Canada case on farming losses — Win, place or show me the money

On August 1, 2012 the Supreme Court of Canada released its decision in Canada v. Craig, 2012 SCC 43. The case involved the deductibility of farming losses incurred by a taxpayer.

Background and decision

The case involved Mr. John Craig. Mr. Craig was a lawyer and his primary source of income was from his law practice. He also had income from investments and gains on the exercise of stock options. In addition, Mr. Craig was in the business of buying, selling, training and maintaining horses for racing. In the years 2000 and 2001, Mr. Craig had losses from his horse racing business of $222,642 and $205,655 respectively. Mr. Craig deducted these losses from his other income. However, the Canada Revenue Agency (“CRA”) reassessed Mr. Craig asserting that subsection 31(1) of the Income Tax Act (the “Act”) applied. If applicable, subsection 31(1) would deny the full deduction of Mr. Craig’s losses in the 2000 and 2001 taxation years from his other sources of income and restrict such losses to $8,750 for each year.

Subsection 31(1) of the Act reads as follows:

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, for the purposes of sections 3 and 111 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 maximum of $8,750]

At the Tax Court of Canada and the Federal Court of Appeal, Mr. Craig was successful in asserting that section 31 did not apply. The Crown sought leave to the Supreme Court and the Court agreed to hear the appeal.

Ultimately, the question in Craig was how section 31 of the Act was to be interpreted. Specifically, the question was under what circumstances the combination of farming and some other source of income constitutes a “chief source of income” allowing the taxpayer to avoid the farm loss deduction limit in section 31. As explained more below, the previous legal standard was that farming income had to be the predominate source of the taxpayer’s income and the taxpayer’s centre of work routine.

This was not the first time the Supreme Court of Canada had looked at the interpretation of section 31. It had the opportunity to decide on a very similar fact pattern in the leading case of Moldowan v. The Queen. The decision of Moldowan has been the subject of much criticism by academics and practitioners. The criticism has focused on whether or not Moldowan correctly interpreted the combination question that the Supreme Court faced in Craig. Accordingly, an interesting question raised in Craig was whether or not the Supreme Court could, if it found that the interpretation of Moldowan was incorrect, override its previous decision. Ultimately the Supreme Court reasoned that it could.

In analyzing Moldowan and why Moldowan was wrong, the Supreme Court had the following to say:

“[10] Similar to this case, Moldowan involved a taxpayer who, in addition to having other sources of income, engaged in the business of farming, namely buying, selling, and maintaining of horses for racing. He sought to deduct his losses from his farming business against his other income. The Minister limited his deductible losses against his other income under s. 13(1) of the Act (now s. 31(1)) to $5,000 (then the limit under that provision). This Court upheld the loss deduction. Dickson J. (as he then was) found that s. 13(1) contemplated three classes of taxpayer involved in farming:

(1) [A] taxpayer, for whom farming may reasonably be expected to provide the bulk of income or the centre of work routine. Such a taxpayer, who looks to farming for his livelihood, is free of the limitation of s. 13(1) in those years in which he sustains a farming loss.

(2) [T]he taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood but carries on farming as a sideline business. Such a taxpayer is entitled to the deductions spelled out in s. 13(1) in respect of farming losses.

(3) [T]he taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood and who carries on some farming activities as a hobby. The losses sustained by such a taxpayer on his non-business farming are not deductible in any amount. [p. 487]

As Mr. Moldowan’s farming business was a subordinate source of income in relation to his other sources of income, he fell into the second class of taxpayer and the farming loss deduction limitation was applicable.

[13] In 2006 in Gunn, Sharlow J.A. engaged in a thorough analysis of Moldowan and the legislative history of s. 31(1). While she endorsed most of Dickson J.’s reasoning, she disagreed with the portion of his analysis that has given rise to criticism, and that is at issue in this appeal. At para. 71, she stated:

“Based on Justice Dickson’s view of the combination question, that person cannot avoid the application of section 31 unless he can establish that his other source of income is subordinate to farming. But if he could establish that, he probably would be able to establish that farming is his chief source of income.”

[28] In this case, I am of the opinion that relevant considerations justify overruling Moldowan. First, Moldowan essentially read the combination test out of s. 31(1). In finding that taxpayers in the second class were subject to the loss deduction limitation where farming as a source of income was a sideline or subordinate to another source of income, the necessary inference was that farming had to be the taxpayer’s chief source of income. However, the section provides two distinct exceptions to its loss deduction limitation. One is where farming is the taxpayer’s chief source of income. The second is where the taxpayer’s chief source of income is a combination of farming and some other source of income. By requiring that the second exception apply only where the other source of income was subordinate to the farming source of income, Moldowan collapsed the second exception into the first. Having regard to the words of the provision, these are two separate exceptions to the loss deduction limitation and each must be given meaning.

[32] I have explained why I am of the view that the interpretation of s. 31(1) in Moldowan cannot stand. It is therefore up to this Court now to approach the question afresh.

[33] While the Moldowan interpretation cannot stand, it is important to bear in mind that substituting a different combination test must not render s. 31(1) incapable of application. Dickson J. was mindful that a simple aggregation of two sources of income would yield just such a result. As he explained in Moldowan, at p. 487:

“It is clear that “combination” in s. 13 cannot mean simple addition of two sources of income for any taxpayer. That would lead to the result that a taxpayer could combine his farming loss with his most important other source of income, thereby constituting his chief source. I do not think s. 13(1) can be properly so construed. Such a construction would mean that the limitation of the section would never apply and, in every case, the taxpayer could deduct the full amount of farming losses.”

[37] All of these authorities support the idea that s. 31(1) does not contemplate a simple aggregation of two sources of income, but requires a wider inquiry into the amount of capital, time, effort, commitment and general emphasis on the part of the taxpayer with respect to the sources of income. There is no requirement that the two sources of income must be connected in order to meet the combination test.

[45] Since the horse-racing activities were a source of income, it remains to determine whether to apply the loss deduction limitation in s. 31(1). Taking 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(1) [emphasis added].”

Ultimately, the Supreme Court found in favor of Mr. Craig that the loss restriction rule in section 31 did not apply given that the combination test was passed.

Implications

The Craig decision is fascinating for a number of reasons including the fact the Supreme Court overrode one of its previous decisions. Frankly, we believe that the Supreme Court “got it right” with respect to the interpretation of section 31. The denial of farming losses using the Moldowan interpretation of section 31 was a routine assessment position of the CRA and much litigated over the last three decades. We are hopeful that the new interpretation will result in much less reassessment activity by the CRA and enable people who have invested considerable time, effort and financial resources to their farming activities to legitimately deduct losses in situations where their efforts have not been rewarded financially.

While Craig involved a horse racing business there are many other taxpayers who engage in more traditional farming activities. It would appear to us that such traditional farming activities (such as cattle ranching, pig farming, poultry farming, grain production and other farming activities) may have a lower threshold for meeting the combination test so that the chief source of income threshold will be met. This compares very favorably to the past when Moldowan was the standard legal test.

In Craig, the Crown agreed that Mr. Craig had a legitimate business:

[44] For s. 31 to apply and for a farming loss to be deductible at all, farming must be a source of income. At trial, the Crown conceded that Mr. Craig’s horse-racing operation was a business, as opposed to a personal endeavour, on the test articulated in Stewart. Accordingly, the trial judge did not have to engage in a Stewart analysis of the facts to determine whether Mr. Craig’s horse-racing operation was a source of income, but accepted that it was a business and not a personal endeavour (paras. 41-42). I see no reason to disturb this conclusion.

While each case will be different, an important hurdle for taxpayers will be to ensure that a legitimate farming business does exist. One can likely expect that the CRA will look at this closely as a future assessing position to try to deny farming losses.

Overall, this is great news for farming taxpayers. Many practitioners and academics would go further and state that this decision is long overdue.