Chapter 5: Income tax

On this page...

• Accounting for your earnings
• Fiscal period
• Income
• Expenses

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This chapter introduces you to the process of reporting earnings and paying income tax on your business's profits. It will explain how to account for what your business earns, and what kinds of income you have to report. It also tells you what expenses you are allowed to deduct.

Accounting for your earnings

Generally, you have to report business income (other than farming or fishing income) using the accrual method of accounting. Farmers or fishers may use the cash method or the accrual method, but not a combination of both.

The accrual method

Under the accrual method, you have to report income in the fiscal period you earn it, regardless of when you receive payment.

Similarly, you deduct allowable expenses in the fiscal period in which you incur them, whether or not you pay for them in that period. Incur usually means you either paid or will have to pay the expense.

The cash method

Under the cash method, you report income in the year in which it is received (whether in cash, property, or services) and you deduct allowable expenses as they are paid in the year in which you actually pay them, except prepaid expenses. If you are a farmer, fisher, or self-employed commissioned sales agent, you can use the cash method.

For more information about the cash method, see Guide T4002, Business and Professional Income, T4003, Farming Income, or T4004, Fishing Income.

How to keep sales and expense journals

You should keep a day-to-day record of your receipts and expenses. A book with columns and separate pages for income and expenses is good for this. Keep this record along with your duplicate deposit slips, bank statements, cancelled cheques, and receipts. This will support your expenditure claims.

How to record your business expenses

You can generally deduct business expenses if you incur them for the sole purpose of producing income. If you claim expenses, you have to be able to back up your claim. You do this by keeping all your business-related vouchers and receipts, and recording all your expenses in a journal, a computerized file, or a software accounting program.

The simplest method of recording these expenses is a basic sheet with columns that list the common categories of expenses. At the end of each month, total each column, and then start a new sheet for the next month.

Fiscal period

You have to report your business income on an annual basis. For sole proprietorships, professional corporations that are members of a partnership, and partnerships in which at least one member is an individual, professional corporation, or another affected partnership, your business income is generally reported on a calendar-year basis.

If you are a sole proprietor or in a partnership in which all the members are individuals, you can elect to have a non-calendar year fiscal period. To do this, use Form T1139, Reconciliation of Business Income for Tax Purposes to file your election. You need to file this form by a specific date. For more information, see Guide RC4015, Reconciliation of Business Income for Tax Purposes.

A corporation’s tax year is its fiscal period. A fiscal period cannot be longer than 53 weeks (371 days). A new corporation may choose any tax year-end as long as its first tax year does not exceed 53 weeks from the date it was either incorporated or formed as a result of an amalgamation. The corporation has to file its income tax return within six months of the end of its fiscal period. When the fiscal year ends on the last day of the month, the return is due on or before the last day of the sixth following month. When the fiscal year ends on a day other than the last day of the month, the return is due on or before the same day of the sixth following month.

The rules governing fiscal periods are complicated. It is a good idea to get familiar with them before you get into business. For more information, see Guide RC4015, Reconciliation of Business Income for Tax Purposes, and T4002, Business and Professional Income.

Note
If you are a GST/HST registrant, your decision about your fiscal period end for income tax purposes may affect your GST/HST reporting periods, as well as your filing and remitting due dates. For more information, see Guide RC4022, General Information for GST/HST Registrants, or call us at 1-800-959-5525.

Income

This part gives you an overview of the business income that you should account for in your records for income tax purposes.

Types of income

During the year, you may receive income from your business and from sources other than your actual sales. If they relate to your business, you have to include them in your business income.

What is business income

Business income includes money you earn from a profession, a trade, a manufacture or undertaking of any kind, an adventure or concern in the nature of trade, or any other activity you carry on for profit and there is evidence to support that intention. For example, income from a service business is business income. However, business income does not include employment income, such as  wages or salaries received from an employer.

Note
You have to report all amounts of income that are required for calculating income for tax purposes. If you fail to report all your income, you may be subject to a penalty of 10 % of the amount of income that you failed to report.

How to account for your business income

Business owners have to provide information about their business income and expenses.

Although we accept other types of financial statements, we encourage you to use the following forms if they apply to you:

• Form T2125, Statement of Business Activities;
• Form T2032, Statement of Professional Activities (for 2008 and future years, Forms T2125 and T2032 will be combined into Form T2125, Statement of Business or Professional Activities);
• Form T2042, Statement of Farming Activities;
• Form T1163, Statement A - AgriStability and AgriInvest Programs Information and Statement of Farming Activities for Individuals;
• Form T1164, Statement B - AgriStability and AgriInvest Programs Information and Statement of Farming Activities for Additional Farming Operations;
• Form T1273, Statement A - Harmonized AgriStability and AgriInvest Programs Information and Statement of Farming Activities for Individuals;
• Form T1274, Statement B - Harmonized AgriStability and AgriInvest Programs Information and Statement of Farming Activities for Additional Farming Operations; and
• Form T2121, Statement of Fishing Activities.

You will find instructions on completing them in the income tax guides on our Web site.

We have designed these forms to accommodate the most common types of income and expense categories used in business, so it should be easy for you to set up your accounting records. You may use the categories included on these forms when you establish your accounting records.

You must also record as income any amount credited to your account or set aside for you as payment for providing goods and services. This also includes amounts credited to your accounts as offsets against an amount you owe.

You must support all income entries in your records with original documents - sales invoices, cash register tapes, receipts, fee statements, and contracts. Keep the supporting documents in chronological or numerical order and make them available if we ask to see them.

You should also keep a separate record of your income from all other sources, such as professional fees, and income from property, investments, taxable capital gains, estates, trusts, employment, and pensions.

Bad debts

If, during the year, you received any amount that you wrote off as a bad debt in a previous year, you have to include the amount in your income for the current year.

For more information, see Interpretation Bulletin IT‑442, Bad Debts and Reserves for Doubtful Debts.

There may be GST/HST implications on the recovery of bad debts. For more information, see Guide RC4022, General Information for GST/HST Registrants.

Reserves

You have to bring any reserve you claimed in a given year back into income in the following year. The Income Tax Act allows you to take a new reserve based on your circumstances at that time.

For more information, see Interpretation Bulletin IT‑154, Special Reserves.

Vacation trips and awards

If you received vacation trips or other awards of any kind (such as jewellery or furniture) as a result of your business activities, you must include the value of these awards in your business income.

Vacation trips and awards may have GST/HST implications. For more information, see Guide RC4022, General Information for GST/HST Registrants.

Government grants and subsidies

If you receive a grant or subsidy from a government or government agency, you have to report it either as income or as a reduction of an expense. Generally, a grant or subsidy:

• increases your income or reduces your expenses;
• relates to an income deficiency; or
• relates to specific expenses.

For example, if you are a farmer and you received a payment to subsidize your income in a drought year, you would add the payment to your income. However, if you are a business that receives a government employment grant to allow you to hire more students, you would generally deduct it from the wage expense you are claiming.

Government assistance that enables you to acquire capital property does not increase your net income. However, in the case of depreciable property, you reduce the capital cost of the property by the amount of the assistance you received. In the case of other capital property, reduce the adjusted cost base accordingly.

For more information, see Interpretation Bulletin IT-273, Government Assistance - General Comments.

Surface rentals for petroleum or natural gas exploration

If you have land that you usually use in your farming or business operation, and you are leasing it out for petroleum or natural gas exploration, you may have to include the leasing proceeds in your income either as a capital receipt or as an income receipt.

For more detailed information, see Interpretation Bulletin IT-200, Surface Rentals and Farming Operations.

Rental income

Rental income can be either income from property or income from business. Income from rental operations is usually income from property.

Do not include rental income, whether from farm property or real estate, with your business or farming income. You have to report it separately on your tax return.

To determine the type of rental income you have, and how to report it, see Guide T4036, Rental Income.

Barter transactions

A barter transaction takes place when any two persons agree to an exchange of goods or services, and carry out that exchange without using money.

If you are involved in a barter transaction, the goods or services you receive could be considered proceeds from a business operation. If you are in a business or profession that provides goods or services, and you offer these goods or services in a barter transaction in exchange for other goods or services, you have to include the value of the goods or services you provided in your income.

Barter transactions may also have GST/HST implications. For more information, see Guide RC4022, General Information for GST/HST Registrants or call us at 1-800-959-5525.

Selling a property

If you sell a capital property, you may have to include certain amounts in your income, such as:

• a recovery of capital cost allowance, known as recapture; and
• part of any capital gain you realize on the sale.

Generally, you have a capital gain or a capital loss when you dispose of capital property. For example, if you sell a piece of land for more than it cost, you have a capital gain as a result. Similarly, if you sell the land for less than it cost, you have a capital loss.

For more information on capital gains and capital losses, see Guide T4037, Capital Gains. For special rules relating to farmers, see Guide T4003, Farming Income.

Also, there may be GST/HST implications when you sell a property. For more information, see Guide RC4022, General Information for GST/HST Registrants.

Inventory and cost of goods sold

To match expenses with income, you need to prepare an annual inventory. This is usually a list of goods held for sale. If you are a manufacturer, this includes raw materials as well as packaging material and supplies, work-in-progress (goods and services that you have not yet completed at the end of your fiscal period), and finished goods that you have on hand. Inventory is used in the calculation of the cost of goods sold, which allows the calculation of net income on Form T2125, Statement of Business Activities or Form T2125, Statement of Business or Professional Activities (for 2008 and future years).

However, if you have a professional practice and you are an accountant, dentist, lawyer, medical doctor, notary, veterinarian, or chiropractor, you may elect to exclude your work-in-progress when you determine inventory.

How to value your inventory

The value you place on the items in your year-end inventory is important in determining your income. For income tax purposes, the two acceptable methods of valuing your inventory are by determining:

• the fair market value of your entire inventory (use either the price you would pay to replace an item, or the amount you would get if you sold an item); or
• the value of individual items (or classes of items, if specific items are not readily distinguishable) in the inventory, at either their cost or their fair market value, whichever is lower.

Once you choose a method of inventory valuation, you must continue to use this method in subsequent years. For more information about valuing inventory, see Interpretation Bulletin IT-473, Inventory Valuation.

Expenses

This section gives you an overview of the business expenses that you can claim for income tax purposes. For more information, visit our Business page or see Guide T4002, Business and Professional Income.

What are business expenses

A business expense is a cost you incur for the sole purpose of earning business income.

You must back up business expense claims with a sales invoice, an agreement of purchase and sale, a receipt, or some other voucher that supports the expenditure. If you pay cash for any business expenses, be sure to get receipts or other vouchers. Receipts should include the vendor's name and the date.

Remember to keep your cancelled cheques if you receive them from the bank. This is part of your proof that the bill was paid or the asset purchased. Keep the cancelled cheques in an orderly manner so we can easily review them.

Running a business from your home

You can deduct expenses for the business use of a work space in your home, as long as you meet one of these conditions:

• it is your principal place of business; or
• you use the space only to earn your business income, and you use it on a regular and ongoing basis to meet your clients or customers.

You can deduct a part of your maintenance costs, such as heating, home insurance, electricity and cleaning materials. You can also deduct a part of your property taxes, mortgage interest, and capital cost allowance (CCA). To calculate the part you can deduct, use a reasonable basis, such as the area of the work space divided by the total area of your home.

For more information, see Guide T4002, Business and Professional Income.

Types of operating expenses

Personal or living expenses

In most cases, you cannot deduct personal and living expenses, except for travelling expenses you incur in the course of carrying on a business while away from home.

The general rule is that you cannot deduct outlays or expenses that are not related to earning business income.

Prepaid expenses

A prepaid expense is an expense you pay ahead of time. If you use the accrual method of accounting, claim any expense you prepay in the year or years in which you receive the related benefit.

For more information, see Interpretation Bulletin IT-417, Prepaid Expenses and Deferred Charges.

Accounting and legal fees

You can deduct the fees you incurred for external professional advice or services, including consulting fees.

You can deduct accounting and legal fees you incur to get advice and help in keeping your records. You can also deduct fees you incur for preparing and filing your income tax and GST/HST returns.

For more information, see Interpretation Bulletin IT-99, Legal and Accounting Fees.

Advertising expenses

You can deduct expenses for advertising, including ads in Canadian newspapers and on Canadian television and radio stations. You can also include any amount you paid as a finder's fee.

Certain restrictions apply to the amount of the expense you can deduct for advertising in a periodical. You can deduct all the expense if your advertising is directed to a Canadian market and the original editorial content in the issue is 80 % or more of the total non-advertising content in the issue.

You can deduct 50 % of the expense if your advertising in a periodical is directed to a Canadian market and the original editorial content in the issue is less than 80% of the total non-advertising content in the issue.

You cannot deduct expenses for advertising directed mainly to a Canadian market when you advertise with a foreign broadcaster.

Business tax, fees, licences, and dues

You can deduct any annual licence fees and business taxes you incur to run your business.

You can also deduct annual dues or fees to keep your membership in a trade or commercial association. However, you cannot deduct club membership dues (including initiation fees) where the main purpose of the club is to provide dining, recreational, or sporting facilities for its members.

Insurance expenses

You can deduct all regular commercial insurance premiums you incur on any buildings, machinery, and equipment that you use for your business.

Interest and bank charges

You can deduct the interest you incur on money you borrow to run your business. However, there are some limits.

There is a limit on the interest you can deduct on money you borrow to buy a passenger vehicle. For more detailed information, see "Motor vehicle expenses" in Guide T4002, Business and Professional Income.

There is also a limit on the amount of interest you can deduct for vacant land.

You can choose to capitalize the interest you pay on the money you borrow for the following purposes:

• to buy depreciable property;
• to buy a resource property; or
• for exploration and development.

In the case of exploration and development, when you choose to capitalize interest, you add the interest to either the cost of the property or the exploration and development costs.

Do not deduct the capitalized interest as a current expense. See "Interest" in Guide T4002, Business and Professional Income. If you need more information, call us at 1-800-959-5525.

Maintenance and repairs

You can deduct the cost of labour and materials for any minor repairs or maintenance done to property you use to earn income. However, you cannot deduct the value of your own labour.

You cannot deduct costs you incur for repairs that are capital in nature. However, you may be able to claim capital cost allowance on the repaired property. A capital expense generally gives a lasting benefit or advantage. For example, the cost of putting vinyl siding on the exterior walls of a wooden house is a capital expense. For more information about capital cost allowance, see Guide T4002, Business and Professional Income.

Meals and entertainment

The maximum part you can claim for food, beverages, and entertainment expenses is 50 % of either the amount you incur or an amount that is reasonable in the circumstances, whichever is less.

The 50 % limit also applies to the cost of your meals when you travel or go to a convention, conference, or similar event. However, special rules can affect your claim for meals in these cases. For an update and more details, see "Meals and Entertainment," "Convention expenses," or "Travel" in Guide T4002, Business and Professional Income.

For more information, see Interpretation Bulletin IT-518, Food, Beverages, and Entertainment Expenses.

Motor vehicle expenses

You can deduct expenses you incur to run a motor vehicle that you use to earn business income. However, several factors can affect your deduction.

What kind of vehicle do you own?

The kind of vehicle you own can affect the expenses you deduct. For income tax purposes, there are three types of vehicles:

1. Motor vehicle - Any automotive vehicle designed or adapted for use on highways and streets. A motor vehicle does not include a trolley bus or a vehicle designed or adapted to be operated only on rails.
2. Automobile - This is a motor vehicle designed or adapted primarily to carry people on highways and streets. It seats a driver and no more than eight passengers.
   
   An automobile does not include:
   • an ambulance;
   • clearly marked police and fire
     emergency-response vehicles;
   • a motor vehicle you bought to use more than 50 % as a taxi, a bus used in the business of transporting passengers, or a hearse in a funeral business;
   • a motor vehicle you bought to sell, rent, or lease in a motor vehicle sales, rental, or leasing business;
   • a motor vehicle (except a hearse) you bought to use in a funeral business to transport passengers;
   • a van, pick-up truck, or similar vehicle that seats no more than the driver and two passengers which, in the tax year you bought or leased, was used more than 50 % to transport goods and equipment to earn income;
   • a van, pick-up truck, or similar vehicle that, in the tax year you bought or leased, was used 90 % or more to transport goods, equipment, or passengers to earn income;
   • a pick-up truck that, in the tax year you bought or leased, was used more than 50 % to transport goods, equipment, or passengers while earning or producing income at a remote work location or at a special work site that is at least 30 kilometres from the nearest community having a population of at least 40,000 persons; and
   • a clearly marked Emergency Medical Service vehicle used to carry paramedics and their emergency medical equipment.
3. Passenger vehicle - An automobile you bought after June 17, 1987. A passenger vehicle is also an automobile that you leased under a lease agreement you entered into, extended, or renewed after June 17, 1987.

With certain exceptions, most cars, station wagons, vans, and some pick-up trucks are considered passenger vehicles. If you own or lease a passenger vehicle, there may be a limit on the amounts you can deduct for capital cost allowance, interest, and leasing costs.

For definitions and more detailed information about capital cost allowance limits, interest limits, and leasing costs, see Guide T4002, Business and Professional Income.

How to record motor vehicle expenses

You can deduct motor vehicle expenses only when they are reasonable and you have receipts to support them.

To get the full benefit of your claim for each vehicle, keep a record of the total kilometres you drove, and the kilometres you drove to earn business income. For each business trip, list the date, destination, purpose, and the number of kilometres you drove.

Be sure to write down the odometer reading of each vehicle at the start and end of the year. If you change motor vehicles during the year, write down the odometer reading at the time you buy, sell, or trade the vehicle. Record the dates of these readings.

What kind of vehicle expenses can you deduct?

The types of expenses you can deduct include:

• fuel and oil;
• maintenance and repairs;
• insurance;
• licence and registration fees;
• capital cost allowance;
• interest you pay on a loan used to buy the motor vehicle; and
• leasing costs.

Joint ownership

If you and another person own or lease a passenger vehicle together, the limits on capital cost allowance, interest, and leasing still apply.

As a joint owner, the total amount you and any other owners deduct cannot be more than the amount that one person owning or leasing the vehicle could deduct.

Business use of a motor vehicle

If you use a motor vehicle for both business and personal use, you can deduct only the portion of the expenses that relates to earning business income.

However, you can deduct the full amount of parking fees related to your business activities and supplementary business insurance for your motor vehicles.

To support the amount you deduct, keep a record of both the total kilometres you drove, and the kilometres you drove to earn income.

The following chart shows you how to keep this type of record.

Note
When you use more than one motor vehicle to earn income, calculate the expenses for each vehicle separately.

Interest expenses on vehicle loans

You can deduct interest on money you borrow to buy a motor vehicle, automobile, or passenger vehicle that you use to earn business income.

Include the interest as an expense when you calculate your allowable motor vehicle expenses. However, when you use a passenger vehicle to earn business income, there is a limit on the amount of interest you can deduct.

For more information, see Guide T4002, Business and Professional Income.

Vehicle leasing expenses

You can deduct the leasing costs of a motor vehicle that you use to earn business income.

Include the leasing costs when you calculate your allowable motor vehicle expenses.

However, when you use a passenger vehicle to earn income, there is a limit on the amount of leasing costs you can deduct.

To calculate your eligible leasing costs, see Guide T4002, Business and Professional Income.

Office expenses

You can deduct the cost of office expenses, which include small items such as pens, pencils, paper clips, stationery, and stamps. Office expenses do not include items such as calculators, filing cabinets, chairs, and desks, which are capital items. For more information, see Guide T4002, Business and Professional Income.

Salaries, including employer's contributions

You can deduct salaries you pay to employees. You report these salaries by the end of February on a T4 slip, Statement of Remuneration Paid, or T4A slip, Statement of Pension, Retirement, Annuity and Other Income. For more details on these slips, see Guide T4001, Employers’ Guide - Payroll Deductions and Remittances.

Can you deduct business start-up costs?

To be able to deduct a business expense, you had to have carried on a business in the fiscal period in which the expense was incurred. Because of this, you have to be very clear about the date your business started.

Determining exactly what you can claim as a start-up expense can be difficult. For more information, see Interpretation Bulletin IT-364, Commencement of Business Operations.

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