A profit test is used by the Canada Revenue Agency (CRA) to determine whether an individual who claims to be operating a business is producing—or intends to produce—a profit. It's important because only a person or legal entity actually operating a business can claim business expenses or business tax credits.
If you are a Canadian small business owner, be sure to understand how the profit test works and how it could affect your business when it comes to taxes.
What Is a Profit Test?
The Canada Revenue Agency (CRA) uses a profit test to determine whether an individual who claims to be operating a business is producing—or intends to produce—a profit. Only a person or legal entity actually operating a business can claim business expenses or business tax credits.
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—and this could create a hefty tax bill.
The CRA defines a business as "an activity that you conduct for profit or with a reasonable expectation of profit."
How Profit Tests Work
The profit test looks at a business and asks, "Was the activity conducted with an actual expectation of profit?" and "Was that expectation of profit reasonable?"
Here's an example. Lucy is a technology consultant, but she has a passion for photography. She decides to quit her job, enroll in digital photography courses, and start her own business as a full-time wedding photographer. In her first year in business, she doesn't turn a profit because she spends more money investing in her education, high-quality equipment, her website, and other marketing materials.
However, Lucy passes the profit test because she can demonstrate that she reasonably expects to produce a profit. In this case, she is eligible to claim business expenses and business tax credits as a small business owner.
Criteria for Passing a Profit Test
Of course, the easiest way to pass a profit test is by proving your business has actually turned a profit. You can show this with a profit and loss statement.
If you haven't yet produced a profit, but you had a reasonable expectation of producing one, pay attention to the criteria determined by the CRA. Your investments, education, qualifications, and more can prove a reasonable expectation for profit.
The CRA'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).
This publication explains the criteria further and provides examples of how the profit test has been applied in particular past cases. It also recognizes that the issue of reasonable expectation of profit "is likely to arise more often" with some types of activities people engage in for-profit, including farming and art/writing.
- A profit test is used by the Canada Revenue Agency (CRA) to determine whether an individual who claims to be operating a business is producing or intends to produce a profit.
- Profit tests are important when it comes to taxes because only a person or legal entity actually operating a business can claim business expenses or business tax credits.
- The easiest way to pass a profit test is by proving your business has actually turned a profit. If your business hasn't yet produced a profit, you'll need to prove you had a reasonable expectation of producing one according to criteria by the CRA.