When is a Business in Business?
Entrepreneurs excited by the prospect of starting
a new business and anticipating a quick startup often purchase assets or make other
expenditures far in advance of actual registration or incorporation. The question then
arises: "Are expenses incurred before registration chargeable against revenues?"
The answer to this apparently simple question is
complicated by a number of factors involving the Income Tax Act and the subjectivity of
timing. It should be noted, however, that, because the Act does not provide specific rules
dealing expressly with start-up costs, the tax planner must be aware of both the
administrative practices of the CRA and the guidance provided in this area by the courts.
The Act indicates that an expense is deductible
only if incurred for the purpose of earning income. Thus, if money were spent to earn
income, these expenditures are deductible only if it can be shown that the taxpayer was
carrying on business in the fiscal period. This means the taxpayer will have to establish
the date the business began and be able to show the expenditures were made as a first step
to the start of normal operations.
When Does Business Commence?
Establishing the moment when a contemplated
business actually becomes a functioning business is a matter of judgement, since "the
moment" depends on the determination of when normal operations begin.
It may be fair to assume that a restaurant, for
example, has started business before the doors opened, if the lease arrangements are in
place, capital assets are being installed, or the owners are running ads and interviewing
for staff. In such a case, the Canada Revenue Agency would want to determine that
significant organizational indicators were already in place to support a planned opening
If, on the other hand, the aspiring restaurateur
spent money only researching the potential of a restaurant at a certain location, it is
likely the CRA would consider the expenditures not connected closely enough with actual
business operations to be deductible.
Significant Tax Impact
Determining whether expenditures are made in
anticipation of an actual business is significant for taxation purposes.
After a business has started, all expenditures
fall into two classes:
expenses to be offset against current revenue
expenditures to be amortized over the useful life of the capital asset.
Amortization is charged as a non-cash expense
against the current and future revenue generated by the use of the capital asset. Certain
expenditures, such as lawyer's and architect's fees etc., that would otherwise be treated
as operating expenses, may be classed as capital expenditures, if they occur before
operations commence and are related to the settlement of capital asset issues. They are
normally added to the specific capital item and offset along with the original capital
cost of the asset against current and future revenue.
The CRA's position is that operating expenses
deemed to have been made before the start of business will not be available to reduce
taxable income for the operational year. Further, if these expenditures result in a
business or non-capital loss, the loss will not be available to apply forward against
subsequent years' taxable income. Thus, the entrepreneur may make expenditures in what
are, in effect, after-tax dollars from which neither the business nor the entrepreneur can
receive a benefit.
Similarly, if capital expenditures are determined
to have been made before the start of business, they might not be viewed as expenditures
for the purpose of generating income. Thus, if the business fails before it begins, the
entrepreneur will have a loss that may not provide any taxable benefit.
As noted, when a business begins is a matter of
judgement. Probably no single factor can be used to establish the inaugural moment. As a
result, whether expenditures made before registration or actual commencement of operations
should be included as a capital or operating transaction is a subjective decision.
Evidence of intent assists in clarifying not only
the time when operations begin but also the timing and allocation of expenditures for
financial- and tax-reporting purposes.
Entrepreneurs should meet with their chartered
accountant even if merely contemplating a new start-up business to determine:
reasonableness of the anticipated time likely to elapse between expenditures and business
possibility of timing expenditures to fall within the same fiscal period as the revenue
assets are purchased only for the site and/or business contemplated
fees, licenses, and permits are dated, receipted and specific to the site or the industry
or letters of intent are in place for leases, franchises, and/or capital asset
is completed within a reasonable time of commencement
expenditures such as site-insurance, building permits, etc., are documented and receipted
to assist in the allocation to either income or capital
Plan, Plan, and Plan Again
Responsible planning when starting a business will
ensure that the entrepreneur can take advantage of the maximum deductible expenses
permitted by the CRA while at the same time satisfying investors and creditors.
This article only provides a cursory overview of
this complicated topic. If you are even considering starting your own business and may
encounter any situation similar to what has been outlined above, consult your chartered
accountant before proceeding.