Kelly Ng Jasmine Lee March 10 2023 Federal Court of Appeal comments on source of income test post-Paletta KPMG Law | Corporate Tax - Canada Kelly Ng, Jasmine Lee Corporate Tax IntroductionFactsTax CourtFederal Court of AppealIntroductionIn Brown v Canada,(1) the Federal Court of Appeal provided further guidance on its rephrased source of income test from its recent decision in Paletta.(2) Source of income is a fundamental concept in Canadian tax law. There can be no taxation without income and, subject to specific exceptions, no income without a source.With respect to the first question of this source test – of whether there is a personal or hobby element to the activity – the Court instructed that a personal reason for conducting an activity cannot, in and of itself, be considered a personal endeavour. This led to a finding that there was no personal element to Darrell Brown's activity.The Court then considered the test's second question – of whether there was a pursuit of profit (which it found to be necessary in a source of income test). The Court found that the evidence demonstrated a pursuit of profit by Brown and referred the matter back to the Tax Court to determine whether the expenses claimed are deductible.FactsIn April 2010, the taxpayer, Brown, and his wife, Lyudmila Bezpala-Brown, opened an art gallery in Toronto. Initially, Bezpala-Brown and a friend primarily managed the art gallery. At that time, Brown, a lawyer, provided the gallery with limited managerial and administrative-type services.In September 2010, Bezpala-Brown became ill – then pregnant – and was no longer able to run the gallery. As a result, Brown became more involved in the gallery business and, in early 2011, he was officially retained to provide management services. The compensation paid to Brown was a management fee, equal to 20% of the amount by which the gallery's annual revenue exceeded C$100,000.Brown provided management services to the gallery in 2011, 2012 and 2013 and, each year, the gallery failed to generate enough revenue to trigger a payment to Brown. The gallery incurred losses in each of the years at issue. Brown claimed non-capital losses of C$90,696 for 2011, C$115,200 for 2012 and C$113,932 for 2013 (which he later conceded were overstated).The minister reassessed Brown to deny the non-capital losses claimed on the basis that his management services activity was not a source of income and that the amounts claimed as expenses were not reasonable.Tax CourtThe Tax Court of Canada dismissed Brown's appeal on the grounds that he did not have a source of business income during the taxation years under appeal.(3) The Court found that Brown's activity had a personal element, and that the activity had not been carried on in a sufficiently commercial manner to constitute a source of business.Through applying the source of income test in Stewart(4) and weighing the evidence, the Court found a personal element to Brown's activities as he had only begun providing management services to the gallery because of Bezpala-Brown's health issues. The Court also concluded – based on the evidence – that Brown's activities had not been carried on in a sufficiently commercial manner to constitute a source of business.Brown appealed the Court's decision.Federal Court of AppealJustice Webb of the Federal Court of Appeal of Canada allowed Brown's appeal and held that the Tax Court had erred in law in its interpretation of Stewart. More specifically, the Tax Court had erred by focusing on Brown's personal reasons for providing the management services to find that this activity was a personal endeavour and not a source of income. Rather, the Federal Court of Appeal stated that the Tax Court should have focused on the activity itself to determine whether there was a personal or hobby element.The Federal Court of Appeal began its analysis with reference to the test in Stewart, and then set out its rephrased approach to determining whether a person has a source of income:Is there a personal or hobby element to the activity in question?If so, the next enquiry is whether "the activity is being carried out in a commercially sufficient manner to constitute a source of income".If not, the next enquiry is whether the activity is being undertaken in pursuit of profit.For the first question, Justice Webb also clarified that the focus should be on the activity itself and whether there is any personal or hobby element to the activity. The Court also clarified that a person's personal motivation or reason for conducting an activity cannot, in and of itself, result in there being a personal or hobby element to the activity. This is because it is possible to find a personal reason why any person is carrying on a particular activity, and this could potentially subject every activity to the reasonable expectation of profit test.In examining Brown's activity (the management services), the Court found that these services allowed the gallery to continue to operate and that there was no indication that there had been any personal or hobby element to the management services. The Federal Court of Appeal found that the Tax Court had erred in finding that there was a personal element because Brown had undertaken his management activities as a result of his spouse's inability to continue to manage the gallery.The Court then considered the second question and stated that the intention to generate profit is necessary in a source of income analysis. Justice Webb clarified that this question is whether the taxpayer is pursuing profit in undertaking the activity in question, not whether this was their predominant intention. The Federal Court of Appeal found that the Tax Court had also erred by focusing on the deductions claimed by Brown because the question of whether a person is pursuing a profit is separate from the question of the deductibility of any expenses claimed.The Court ultimately concluded that Brown had been in pursuit of profit in providing the management services because this activity was inextricably linked to the gallery business (his revenue was a percentage of the gallery's gross revenue) and his services allowed the gallery to continue to operate until it could generate sufficient revenue to cover its expenses. The Court found that Brown's intent was to allow the gallery to generate revenue which, in turn, would generate the management fees payable to him (ie, profit for his management services activity).For further information on this topic please contact Kelly Ng or Jasmine Lee at KPMG Law by telephone (+1 416 777 8000) or email ([email protected] or [email protected]).The KPMG Law website can be accessed at kpmg.com/ca/en/home/services/kpmg-law.html.Endnotes(1) Brown v Canada, 2022 FCA 200.(2) Canada v Paletta Estate, 2022 FCA 86.(3) Brown v The Queen, 2020 TCC 123.(4) Stewart v Canada, 2002 SCC 46.