Profit Test: The Canada Revenue Agency's (CRA) Definition of Business
Failing the profit test can have grave tax consequences
The profit test refers to the business definition used by the Canada Revenue Agency (CRA) and is used to determine whether or not a person who claims to be operating a business is.
Only a person (or legal entity) actually operating a business can claim business expenses or business tax credits. So, if a person claims to be operating a business on his or her Canadian income tax return or GST/HST return and that business does not pass the profit test, all of the claimed business expenses and relevant tax credits would be disallowed - creating a hefty tax bill.
How Does the CRA Define a Business?
The Canada Revenue Agency defines a business as "an activity that you conduct for profit or with a reasonable expectation of profit."
The profit test asks, "Was the activity conducted with an actual expectation of profit?" and "Was that expectation of profit reasonable?"
The Canada Revenue Agency's P-176R - Application of Profit Test to Carrying on a Business publication defines the following criteria for determining the reasonable expectation of profit for a business activity by an individual:
- The profit and loss experience in past years;
- The amount of gross income, if any, reported over several years;
- The length of time over which a profit could reasonably be expected to be shown must be relevant to the nature of the activity. For example, in the case of a tree farm, the relevant time period might be longer than a vegetable farm;
- The extent of activity in relation to that of businesses of a comparable nature and size in the same locality;
- The amount of time spent on the activity in question;
- The individual's qualifications, such as experience, training, and education, including his/her eligibility for membership in a professional association;
- The qualification of the individual for public assistance given to those who are carrying on a business in that field of activity;
- The individual's intended course of action, as evidenced by his/her efforts showing an intention to make a profit (e.g., the preparation of a business plan);
- The capability of the venture as capitalized to show a profit after charging depreciation, and the development of the operation and commitments for future expansion according to the individual's available resources. It includes the ability to secure proper and reasonable financing to make the venture a viable business capable of showing a profit;
- The degree of effort in promoting and marketing the products or services supplied by the individual as, for example, the registration of a trading name and the opening and maintaining books and records;
- The type of expenditures claimed and their relevance and reasonableness to the activity (i.e., will the expenditure enhance the ability to make a profit); and
- The nature of the product or service supplied, such that it has a profit potential (i.e., a market exists or can be developed).
The publication explains the issue further and provides examples of how the profit test has been applied in particular past cases. Also discussed is the recognition that the issue of reasonable expectation of profit "is likely to arise more often" with some types of activities people try to engage in for-profit; both farming operations and artists and writers are discussed in depth.