Application of Profit Test to Carrying on a Business (Revised Sept 30, 1998)

Please note that the following Policy Statement, although correct at the time of issue, may not have been updated to reflect any subsequent legislative changes.

GST/HST policy statement P-176R

Date of Issue

March 31, 1995
Revised September 30, 1998

Subject

Application of Profit Test to Carrying on a Business

Legilsative Reference(s)

Subsection 123(1) ... paragraph (a) of definition of "commercial activity" from April 24, 1996

Subsection 123(1) ... paragraph (a) of definition of "commercial activity" for the period subsequent to September 1992, up to and including April 23, 1996

Subsection 123(1) ... paragraphs (a) and (e) of definition of "commercial activity" prior to October 1992

National Coding System File Number(s)

11635-9

Effective Date

January 1, 1991 for GST
April 1,1997 for HST

Text

Issue and Decision:

This policy statement provides criteria for determining whether a business is being carried on without a reasonable expectation of profit and therefore does not constitute a commercial activity. The policy does not address an adventure or concern in the nature of trade nor a supply of real property (except where the supply of the real property constitutes the carrying on of a business). These latter types of activities will be addressed in separate policy statements.

The reasonable expectation of profit test (referred to as the "profit test" elsewhere in this policy statement) does not apply to persons who are not individuals, such as corporations, partnerships (not composed solely of individuals subsequent to September 1992), trusts and so on. This is because the definition of business in subsection 123(1) states, in part, that a business "includes a profession, calling, trade, manufacture or undertaking of any kind whatever, whether the activity or undertaking is engaged in for profit". There is accordingly no profit test for a person who is not an individual. Such a person, if it is registered, must collect tax on the supplies it makes and is eligible for input tax credits even if it has no reasonable expectation of profit, provided that its activities otherwise qualify as commercial activities. Policy statement P-167 on the "Meaning of the First Part of the Definition of Business" provides criteria for determining whether an activity is "a profession, calling, trade, manufacture or undertaking of any kind whatever".

The profit test is well developed in the income tax area. There are numerous cases which discuss the term in the context of specific fact situations. Criteria have been developed for determining whether a particular activity was undertaken with a reasonable expectation of profit. Interpretation Bulletin IT-322R explains the criteria for farmers and Interpretation Bulletin IT-504R explains the criteria for visual artists and writers. This policy draws upon those criteria.

It should be kept in mind that merely showing a gain on a sale does not establish that a person has a commercial activity. A person who makes a supply for consideration greater than the expenses involved in making the supply has a profit, but he/she will still not have a commercial activity unless the supply comes within paragraphs (a), (b) or (c) of the definition of commercial activity. For example, an individual sells a painting to his/her neighbor that has appreciated in value. He/she has never sold paintings before and had originally acquired the painting for his/her own personal use and so used it. He/she does not intend to buy any paintings for resale in the future. At the time of the acquisition of the painting by the individual there was no intention to sell the painting and there was no expectation of profit in any event. Therefore, the sale of the painting to his/her neighbor does not constitute a business or an adventure or concern in the nature of trade. Consequently, the individual is not engaged in a commercial activity, even though he/she made a profit on the sale. To determine whether a particular activity is a business, reference should be made to Policy Statement P-167 on the "Meaning of the First Part of the Definition of Business".

The concept of whether an organization is performing an activity for a purpose other than profit is an important one for the non-profit sector. There are several issues surrounding the concept of profit as it relates to the public sector and the criteria provided in this policy should not be relied upon to determine whether an organization would be considered to be non-profit. For example, the definition of "non-profit organization" in subsection 123(1) and the entitlement of selected public service bodies to rebates under section 259 hinge on whether an entity is organized (or established) and operated for a purpose other than profit. When determining whether an organization is a non-profit organization, the Department has looked to the Income Tax Act for guidance but has relied on criteria developed for the non-profit sector.

Whether an individual has a reasonable expectation of profit is an objective determination to be made from all of the facts and based on the activities actually undertaken by the individual. A subjective profit motive is not sufficient; there must be an objective profit expectation based on an analysis of the activity using the criteria below. Further, it should be noted that it is the "expectation" of profit that is being assessed, not the actual realization of those profits, and that "reasonable" refers to the expectation of profits, and not whether the profits are reasonable.

Generally, the following criteria should be considered when determining whether an activity engaged in by an individual has a reasonable expectation of profit:

1. The profit and loss experience in past years;
2. The amount of gross income, if any, reported over several years;
3. 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;
4. The extent of activity in relation to that of businesses of a comparable nature and size in the same locality;
5. The amount of time spent on the activity in question;
6. The individual's qualifications, such as experience, training and education, including his/her eligibility for membership in a professional association;
7. The qualification of the individual for public assistance given to those who are carrying on a business in that field of activity;
8. 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);
9. 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. This includes the ability to secure proper and reasonable financing in order to make the venture a viable business capable of showing a profit;
10. 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;
11. 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
12. The nature of the product or service supplied, such that it has a profit potential (i.e., a market exists or can be developed).

No particular factor described above is more important than another and no one factor determines whether or not an activity is carried on with a reasonable expectation of profit. All relevant criteria should be considered together in making a determination and the individual's failure to meet any one particular factor will not in itself preclude the individual's activities from qualifying as a commercial activity. However, in certain circumstances only one factor could be sufficient to determine if an individual has a reasonable expectation of profit. For example, an individual may have access to large amounts of capital, may be willing to spend extensive amounts of time on the activity, may have the relevant experience, but if it is clear that there is no market nor potential for a market for the product or services being offered, then there is no reasonable expectation of profit.

The specific factors to be considered in making such a determination will differ with the nature and extent of the activity or undertaking. In addition, unique criteria can be developed for specific types of activities where the issue of reasonable expectation of profit is likely to arise more often.

Farming Operations

One such area is farming, particularly where the farming is done on a part-time basis (i.e., hobby farms). More specifically, in determining whether or not a farming operation undertaken by an individual has a reasonable expectation of profit and, therefore, can be considered a commercial activity, the following are some of the criteria which should be considered (many of these criteria are similar to the general criteria outlined in the previous section and represent a more specific application of those criteria):

1. The extent of activity in relation to a of businesses of a comparable nature and size in the same locality. The main test is the size of the property used for farming. If the land farmed is much too small to give any hope of profit, the presumption is that the property is being held for personal use or enjoyment of the individual. On the other hand, where the land is large enough to be profitable, it may still not be a commercial activity, in certain circumstances. Where for example, the individual has made no attempt at farming or developing the land and has no viable plans to do so, it is presumed the land is held for personal use or enjoyment, or as an investment. This is particularly so where the individual has a more or less regular job and devotes little time to the farm. This also assumes that the individual has not employed other persons to carry on a farming operation. The farm may also not be a commercial activity where the individual, over a number of years, has demonstrated that there was no intention of utilizing more than a fraction of the land (e.g. the individual who buys a farm but uses only one field as a paddock for one or two horses);
2. The time spent on the farming operation in comparison to the time spent in employment or other income-earning capacity. If the individual spends most of his or her time during the crop season attending to the farm, there is a strong presumption that he or she is carrying on a commercial farming activity with an expectation of profit. This is particularly so where the individual has a farming background or experience;
3. The development of the farming operation and commitments for future expansion according to the individual's available resources. This test is based on the capital investment of the individual in the operation over a number of years and on the acquisitions of buildings, machinery, equipment and inventory by the individual;
4. The experience, education and training in the farming business. If prior to undertaking the activity, the individual had no farming experience except gardening for household use and was raised in urban communities, there is a strong presumption that she or he is not in commercial activity; and
5. The qualification of the individual for some type of provincial farming assistance. The particular assistance program may be useful to determine whether the granting authority requires or presumes the recipient to be in the business of farming.

The most common indication that an individual's farming operation does not constitute a commercial activity because of a lack of a reasonable expectation of profit is that it reports no, or a very small amount of, revenue for several years. However, consideration must be given to the fact that such a situation may arise in the first years of a farming operation or may be the result of extraordinary circumstances, such as extremely adverse weather conditions (e.g., prolonged drought, severe hail, frost or flood).

Artists and Writers

Another area where this issue may arise frequently is visual artists and writers. The nature of art and literature is such that a considerable period of time may pass before an artist or writer becomes established and profitable. Although the existence of a reasonable expectation of profit is relevant in determining the presence of a commercial activity, in the case of artists and writers it is recognized that a longer period of time may be required in establishing that such reasonable expectation does exist.

Factors which can be considered in determining whether or not an individual who is an artist or writer has a reasonable expectation of profit include (again, many of these criteria are similar to the general criteria outlined previously and represent more specific application of the criteria):

1. The amount of time devoted to the artistic or literary endeavor;
2. The extent to which an artist or writer has presented his or her own works in public and private settings including, but not limited to, exhibiting, publishing and reading as is appropriate to the nature of the work;
3. The extent to which an artist is represented by an art dealer or agent and the extent to which a writer is represented by a publisher or agent;
4. The amount of time devoted to, and type of activity normally pursued in, promoting and marketing of the artist's or writer's own works;
5. The amount of revenue received that is relevant to the artist's or writer's own works including, but not limited to, revenue from sales, commissions, royalties, fees, grants and awards;
6. The historical record, spanning a significant number of years, of annual profits or losses relevant to the artist's or writer's exploitation of his or her own works;
7. A variation, over a period of time, in the value or popularity of the individual's artistic or literary works;
8. The type of expenditures claimed and their relevance to the endeavor (for example, in the case of a writer there would be a positive indication of a reasonable expectation of profit if a substantial portion of the expenditures were incurred for research);
9. The artist's or writer's qualifications as an artist or writer respectively as evidenced by education and also by public and peer recognition received in the form of honors, awards, prizes and/or critical appraisal;
10. Membership in any professional association of artists or writers whose membership or categories of membership is limited under standards established by that association;
11. The significance of the amount of revenue derived by an artist or writer from the exploitation of his or her own works and the growth of such revenue over time. In applying this factor, external influences such as economic conditions, changes in the public mood, etc., which may affect the sale of artistic or literary works will be taken into consideration; and
12. The nature of the literary works undertaken by a writer. It is considered that a literary work such as a novel, poem, short story or any non-fictional prose composition that is written for general sale or syndicated distribution would normally have a greater profit potential than a work undertaken for restricted distribution.

In the case of an artist or writer, it is possible that an individual may not realize a profit during his or her lifetime but still have a reasonable expectation of profit. However, in order to have a reasonable expectation of profit, the artistic or literary endeavor, as the case may be, must be carried on in a manner such that, based on the criteria outlined above, they may be considered to be a commercial activity rather than a hobby.

It should be noted that although farming and the visual arts and writing are the areas most subject to litigation in an income tax context on the question of reasonable expectation of profit, the courts have examined the issue in other areas such as an electronics repair business, property rental, daycare, clothing manufacturing, a restaurant and the operation of a boat for charter.

As noted above, when dealing with activities such as tree farming, which take a number of years to establish a pattern of behavior that indicates an expectation of profit, it is desirable, where possible, to look at the activity over a significant period of time. However, where a person first establishing such an activity applies for registration, there will not be a history of profit or loss in previous years available for consideration. Thus, this criteria cannot be used in determining whether such a person should be allowed to register. The other factors outlined earlier would have to be relied upon, and registration permitted or denied on that basis.

The fact that a person has been registered in such a situation and has had their input tax credit claims allowed for a number of years is not conclusive evidence that he/she has a reasonable expectation of profit. As with any registrant, such a person is subject to audit and if it is determined that there was no reasonable expectation of profit and therefore no commercial activity, any input tax credit claims previously allowed are subject to assessment.

ILLUSTRATIVE EXAMPLES