Taxpayer Fights Restricted Farm Loss Rules and Wins

Farmers with off farm income are probably familiar with Section 31 of the Income Tax Act. It provides the rules for how much of any farm losses a taxpayer is able to write off against his income from all sources.

Douglas Gunn of Ontario is a farmer and a lawyer. Arguing that his 2 careers were closely linked, he challenged the restriction on farm losses he can apply to his whole personal income. The case went to appeal court, and Gunn won.

Farmers with off farm income are probably familiar with Section 31 of the Income Tax Act. It provides the rules for how much of any farm losses a taxpayer is able to write off against his income from all sources. This section on restricted farm losses has been the basis for many court challenges over the years and most decisions have not been in the taxpayer’s favour. Recently, however, the Federal Court of Appeal overturned a lower court ruling against one taxpayer who was both a farmer and a lawyer.

Since the late 1960s, Douglas Gunn had practiced law in a small town in Ontario. By the mid-’80s he had set up his own law firm and in 2005 had 4 other lawyers working for him.

Over roughly the same time period, Mr. Gunn also built up his farm operation, adding various properties to his interests along the way. By 2005 Mr. Gunn had a herd of about 50 breeding cows and was growing rye, hay and tobacco, his major cash crop.

With help from his wife, Mr. Gunn did most of the work in the cattle operation. He made all of the decisions with respect to livestock breeding and did all of the required paperwork and record keeping. He also did much of the manual work of seeding and haying, hiring casual help as needed.

Mr. Gunn estimated that he spent about 70% of his time at his law practice and 30% on farm work. While his law practice had required a modest capital investment, it had been consistently profitable. The farming operation, on the other hand, had required a significantly higher capital investment, but had seen operating losses in all but two of the past 15 years.

The court case relates specifically to tax years 1997, 1998 and 1999 when the Canada Revenue Agency restricted Mr. Gunn’s farming losses to the amounts as set out in subsection 31(1) of the Act, which as interpreted by the Supreme Court of Canada puts farmers into one of 3 categories:

• Those who derive the bulk of their annual income from farming or from a combination of farming and some other source. They are entitled to write off all of their farming losses against all sources of income without any restrictions.
• Those who do not rely solely on farming for their income. For these taxpayers farming is a sideline business and the amount of farming losses that can be deducted against all sources of income is restricted to a maximum of $8,750 per year.
• Those for whom farming is a hobby instead of a source of livelihood. These taxpayers cannot deduct any losses incurred in their farming activities.

Since Mr. Gunn spent only about 30% of his time on his farming operation, CRA had alleged that farming was a sideline business to his main source of income — the practice of law. Therefore, for the years 1997 through 1999 they had restricted his eligible losses from the farm to $8,750 per year.

When Mr. Gunn appealed to the Tax Court of Canada, he argued that his law practice and farming business were closely inter-related to one another. He had been involved in several agricultural and cattle organizations, and through these he came in contact with many people who eventually became clients or referred other clients to him. For the tax years in question, Mr. Gunn estimated that 10% to 15% of his new clients were ones he had met through his farming activities.

While the Tax Court acknowledged that Mr. Gunn had always been serious about farming and devoted much of his time to these activities, it ruled that farming never displaced law as the activity that took most of his time and provided the bulk of his income. In addition, although the farming operation made a profit in 2002 and 2004, the judge was not convinced that this trend would continue. Mr. Gunn’s appeal was dismissed.

So Mr. Gunn took his argument to the Federal Court of Appeal in April 2006.

Since the Act doesn’t define “chief source of income” referred to in Section 31 and does not indicate whether farming income needs to be predominant if a taxpayer’s chief source of income is a “combination of farming and some other source”, the appeal court traced the history of rules regarding farm losses and prior precedent-setting cases in forming its judgment.

In his ruling, which overturned the Tax Court judgment, the appeal court judge indicated the following:

• There was no evidence to support the Tax Court’s judgment that Mr. Gunn’s farming operation showed no potential for profit.
• While a factual connection between farming and another source of income is not a precondition in the issue of combined farming and other income as the chief source of income, the existence of a connection is not irrelevant. Since Mr. Gunn’s day-to-day life involved both farming and the profession of law, the contacts he made in farming became valuable to his law practice. This evidence of the unique “synergy” between his farm and law practice should be given some weight.
• In addition to the factual connection, Mr. Gunn’s farm and law practice together comprised virtually all of his income and most of his business-related capital. His farm investment and losses were subsidized by his law practice, leaving a substantial income overall. Therefore, Mr. Gunn’s chief source of income was a combination of farming and the practice of law.
• Given his substantial investment of capital, time and expertise and undisputed evidence of farm profit potential, Mr. Gunn’s farming was more than a sideline activity.
• Given all of the above, the appeal court awarded Mr. Gunn full deduction of his farm losses for the years in question. The Crown has not filed an appeal to the Gunn decision.
• Based on the ambiguous wording and lack of clear policy purpose of the current Section 31, it’s certain that taxpayers and CRA will continue to litigate over its application in the courts. Farmers who have significant sources of off-farm income and who are incurring and deducting full farming losses should seek professional tax advice to determine the risks of a CRA challenge based on their specific situations.