Business owners, freelancers and self-employed people have many questions about what they can and can’t write off for their taxes.
This is a potentially endless topic. There are an infinite number of possible businesses, with an infinite number of ways they can be run; meaning there are an infinite number of potential business deductions. The Canada Revenue Agency (CRA) has certain rules to limit or even prohibit certain expenses, but it’s a relatively short list. The validity of the vast majority of business expenses is left undefined* until CRA performs an audit and makes a specific ruling. Consequently, if you go Googling to try and find out if a particular expense is allowed by CRA, it’s statistically unlikely you’ll find any information at all.
Instead, what you have to go by is CRA’s underlying principle of business expenses, the philosophy that guides them when an auditor comes knocking and tries to determine whether to allow or disallow a particular expense as a business deduction. Fortunately, that principle can be expressed in just three words:
The Reasonable Expectation of Profit.
This tiny phrase is packed with everything you need to know, in a very compact package. Every word is important. We’ll take them in reverse order.
Profit is what’s left of your revenue after you subtract your business expenses. You charge $10 for something with associated costs of $3, so you have a profit of $7. When you decide to spend money on your business, it must be with the intention of earning back more in revenue by virtue of that expense; and the increase in revenue must exceed the cost. For example, if you pay $500 for a Facebook ad, it must be that you are aiming for at least $501 in additional income resulting from that ad. Enough to pay for the ad, and leave you with more money than you started with.
This is a tricky one. What it means is that you don’t actually have to show that a given expense actually turned a profit. Say you post your Facebook ad, and it only generates $200 in additional income. Expecting the profit, not the actual outcome, is what matters. The fact that the ad didn’t pan out as you’d hoped does not mean that the ad was not an allowable business expense, so long as you expected otherwise.
This is the greyest area of the question. In this case, Reasonable represents the concept of ‘in the judgement of a reasonable person.’ So your Facebook ad cost $500 and only generated $200. Was it unreasonable to think it would be otherwise? What if instead of a Facebook ad, you printed up a single flyer and posted it somewhere no one ever goes? Would it be reasonable to expect over $500 in increased revenue based on that flyer? On the other hand, maybe your Facebook ad was expected to reach 10,000 people, all of whom need your product and have the income to buy it. Maybe then the expectation was reasonable, even if it didn’t pan out.
The Reasonable Expectation of Profit is the yardstick by which CRA assesses all business deductions that aren’t specifically prohibited by the law. In fact, it should be the yardstick of anyone who is trying to make a living through self-employment or a business. If a potential business expense fails the Reasonable Expectation of Profit test, the first person to reject it should be you, the business owner. Don’t spend money on your business if it’s not going to result in profit!
Your business itself must pass this test: given what it’s going to cost you, does your business provide the reasonable expectation of profit?
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*Just because you’ve written off a particular expense in the past and not been questioned about it doesn’t mean that the expense has been ‘allowed’ by CRA. Most tax returns sent to CRA are subject to little or no scrutiny, unless and until CRA decides to take a closer look. Unless you’ve been audited (and trust me, you’d know!) and CRA has specifically asked about an expense and allowed it, you absolutely can’t know whether CRA would approve of that business expense. What we strive for in Two Minute Tax Tips (and Personal Tax Advisors overall) is audit-proofing: ensuring that the client has the best chance of passing an audit unscathed — or at the very least that they know what the risks are.