Not all income is created the same and the CRA requires that different types of income are reported differently. It is very important that you understand the differences between the types of income and how they are reported to the CRA. The type of income earned can significantly change the treatment from a tax perspective. For instance different expenses can be deducted against business income than employment income. We will discuss the most common forms of income, and how they are reported on a personal tax return (also known as your T1).
Employment income is any income earned as an employee. When you work for a business or entity and receive compensation from that entity, you have earned employment income. Employment income includes income earned from salaries, wages, gratuities, other income inclusions (such as taxable benefits) and stock option benefits. Employment income reported on a calendar basis and is taxed on a cash basis meaning only amounts received are taxed. Typically employment income is reported (by the employer) on a T4 Statement of Remuneration Paid slip, which is included in your personal tax return as employment income.
Business income is any income earned by a business. The CRA considers business income to be any income earned in a:
- manufacture or undertaking of any kind,
- adventure or concern in nature of trade,
- or any other activity carried for profit, with evidence of an intention to produce profit.
Any income you receive in connection with the business is considered taxable.
Note that business income does not include employment income (discussed above). Also generally speaking, business income does not include any rental income (or property income). All income generated from renting space and providing basic services should be reported separately as rental income.
Business income is reported on the accrual basis of accounting. Simply put this means that income and expenses must be recorded when incurred, not when the cash is received/paid. For example, if you complete a project before the current year end, however the customer has 30 days to pay you for that project; it would be considered income in the current period. The same stands true for expenses. If you receive goods or services before the current year end, but have two weeks to pay for them, they would be considered expenses in the current period, regardless of when they are paid.
Business income is reported on a personal tax return using the T2125 Statement of Business or Professional Activities form. This form is used to summarize the total revenues or gross income, then deduct all cost of goods sold and business expenses to come to the businesses net income. Note that reporting for some expenses (for instance CCA, eligible business use of home expenses and vehicle expenses) require you to prepare additional forms. In addition to the T2125, if there are additional reporting requirements if your business collects and remits GST and/or has Employees.
In most situations, where the business is operated as a partnership between a number of partners, the net income for the business is distributed between partners based on the agreed income distribution or ownership. This is calculated on the T2125 form Statement of Business or Professional Activities form discussed above.
Generally, a partnership does not pay income tax on the income it earns and will not file an income tax return, which is different than a corporation (discussed below). Instead, as mentioned above each partner files an income tax return to report their share of the partnership's net income or loss. This requirement for each partner to report their share of the partnership's net income is the same whether the share of income was received in cash or as a credit to one of the partnership's capital accounts, or basically an increase to their right/ownership in the partnership.
There are certain criteria (generally larger partnerships) that may require a Partnership Information Return (Form T5013).
From a tax perspective, a corporation is treated as a legal entity, separate from the individuals owning it and is required to report and file a corporate income tax return (or T2). The corporation will pay taxes much the same as an individual, however the rules, rates and requirements for reporting and paying income tax for a corporation are much different than those set out for individuals.
After the corporation has paid corporate, the income earned from the corporation can only be paid out to individuals (or shareholders) through dividends. Dividends are then taxed as investment income on the personal level.
See the topics on Corporate tax for more information on considerations for incorporation as well as filing and reporting corporate income.
There is no one correct system for record keeping for tax purposes, however if you are carrying on a business or engaged in a commercial activity in Canada, by law the CRA requires you to keep adequate records. Generally speaking, adequate records involve evidence to support all income and expenses. Your records will need to provide enough details to determine your tax obligations and entitlements and will have to be supported by original or source documents (such as invoices, bank statements, deposit slips, cancelled cheques).
It is important that you find a system that works for you and your business, depending on the size and the nature of your business this system can be very different. Some systems are very simple in nature, for instance using excel to track your income and expenses for each month of the year and collecting and organizing supporting documents accordingly. Larger businesses may have very complex accounting systems in place, which allow multiple users to make entries, track hundreds of expense and revenue entries and can produce very detailed reports. See the software section for a discussion of considerations for accounting software.
One of the largest struggles for owner-managed small businesses is separating or tracking business and personal expenses. It is important that you are able to support that all of your expenses actually relate to your business and that you have recorded all of your receipts. If you fail to keep adequate records, in addition to potential penalties, the CRA may assess personal receipts as business income, or deny your business expenses inflating your taxable income and ultimately your tax payable. The easiest way to avoid these issues is to separate your personal and business finances. Setting up separate bank accounts, although not alone good record keeping, can help to separate your business and personal finances. This will help to eliminate the chances of paying for business expenses with personal funds that are not recorded. It will also reduce the risk of the CRA suspecting that personal receipts are actually business income.
The CRA defines a business expense as: “A cost incurred for the sole purpose of earning business income”. As expected, depending on the nature of the business you are running, the expenses are going to be quite different. As such the CRA has used a very broad definition to allow all sorts of expenses to be eligible deductions. As a general rule or test, you need to think about whether the expense is directly incurred for gaining, producing or maintaining income and can be expected to generate income related to your business.
There is no set or list of deductible expenses, however some examples of common types of business expenses are:
- Meals & Entertainment
- Dues, fees, memberships, and subscriptions
- Office supplies
- Legal, accounting and professional fees
- Maintenance and repairs
- Salaries, wages and benefits
- Travel costs
Costs that are not eligible
The CRA has a general rule that you cannot deduct any expense that is not directly related to earning business income. Does that sound familiar? Similar to the deductible expenses, there is no set rule or list of expenses that are not allowed. Again, depending on the nature of the business, the costs related to producing income can be very different.
There may be exceptions, however some examples of common types of non-deductible expenses are:
- Personal expenses, or personal portion of expenses
- Living expenses such as food and clothes(with the exception of travelling for business)
- Mileage or travel to and from your regular workplace
- Penalties, fines or tickets
- Donations to charities or political parties
- Principal portion of payments made for mortgage
- The value or salary paid for your own labor
- 50% of meals & entertainment are considered non-deductible
- Recreational club dues (such as golf fees)
Business Expenses – Common Misconceptions
I drive my car for work, can I claim those costs?
If you use your vehicle for business you can deduct a portion of the costs associated. In order to do so you must track the number of km’s driven on each business trip. Note that you cannot deduct the trips from your home to your regular workplace, these are considered personal. You can than deduct the proportion of the costs related to that vehicle based on the proportion of personal and business km’s. Examples of some of the costs related to the vehicle are: fuel, oil, insurance, licensing, maintenance and repairs. The CRA requires that maintain a log which shows the total personal and business km’s driven in the year as well as maintain evidence for all of the costs claimed.
I have an office in my home, can I claim those costs?
You can deduct the costs related to a home office, or home workspace of any kind, if you use the space as your principal place of business. If not, than the space must be used only for business purposes and you must use the space on a regular and on-going basis to meet with your clients or customers. So, if you have a home office that you use in the evenings to get extra work done, but you do not meet any clients or customers there, you cannot deduct any costs. Similarly, if you have an office, but it doubles as a guest room, or any other personal function, you cannot deduct any costs.
If you have determined that you do have a workspace that is deductible, you may be allowed to deduct a portion of your home expenses such as: heating and utility costs, insurance costs, parts of your property taxes and parts of your mortgage interest. To calculate the portion that you can deduct you must use a reasonable basis. The most reasonable basis is usually the area of the workspace divided by the total area of the home.
I trade services with a business across the street, but no money is exchanged, I don’t need to claim those.
Actually no, the CRA refers to any trading of goods or services as a barter transaction. An example of a barter transaction is one bookkeeping business provides free services to an advertising business in exchange for advertising services. In this case both businesses would have to include the services as business income based on the fair value of the services provided.
There are two types of expenses, current and capital. Current or operating expenses are costs incurred in the day to day operation of the business. Some examples would be: meals & entertainment, office supplies, rent, telephone and utilities. Generally the benefit is derived from these expenses when they are incurred and as such they are deductible in the year that they are incurred.
Capital expenses on the other hand are costs incurred for items such as: tools & equipment, furniture, buildings & fixtures, machinery & equipment. Given that the benefit of these items is not derived in the year the costs are incurred (as many are long term assets) the CRA does not allow the deduction in the current year. Rather the deduction is taken over a number of periods using a system called Capital Cost Allowance or CCA.
CCA allows you to deduct the total cost of the asset purchased over a number of years. If you are familiar with depreciation, it follows the declining balance method. Each year, you are allowed to deduct up to a maximum CCA based on the rate allowed for asset class. The CRA dictates different classes of depreciable property based on the type of asset and sets a maximum CCA rate, for instance Class 1 is for buildings acquired after 1988, the rate for Class 1 is 4%. Depending on the asset being purchased, it will be put into a different class with a different rate. When you purchase an asset, the cost of that asset is added to the Undepreciated Capital Cost or UCC. The total UCC for each class is then multiplied by the rate to determine the maximum CCA.
For example, if you owned furniture (class 8) with a UCC of $10,000 you would be allowed to deduct up to 20% (the CCA rate for class 8) in the year or $2,000.
For more information and a list of classes and applicable rates see the CRA website.
CRA Website- Capital Cost Allowance:
A corporation is a separate legal entity that is owned and presumably controlled by one or more shareholders through shares or a legal entitlement to the profits that a corporation produces. A Corporation is a separate entity from its creators, owners and operators and is given separate legal rights. Although most commonly set up to run profit oriented businesses, corporations can also be set up for not-for-profit initiatives.
Corporations Canada oversees and manages the registration or incorporation of businesses. It is important to note that there are a number of advantages and disadvantages to incorporating a business, and the decision to do so should not be undertaken lightly.
As mentioned in the types of income, a corporation is taxed much differently than a business ran in a sole proprietorship or partnership. Given that a corporation is a separate entity, it must report separate income, calculated at the corporate level and reported on a T2 corporate tax return. This after-tax income can then be distributed to shareholders in the form of a dividend.
There are many considerations that must be made in the decision as to whether to incorporate or not.
Limiting liability from a separate entity
As a separate legal entity, there may be opportunities to limit your liability by separating yourself from the business. If you're a sole proprietor, your personal assets for instance your house or your car can be seized to pay the debts of your business. The corporation can limit this liability. As a shareholder in the corporation, you cannot be held responsible to pay the debts of the corporation, you can only lose what you put into it the corporation.
Income distribution, continuance and planning
With a corporation there may be opportunities to set up more complex income distribution schemes, allowing more freedom in the amount of income removed from the business. It may also allow for some succession planning, the corporation can continue to operate the business after its shareholders leave, retire or even die.
Additional opportunities for tax planning and tax deferral
There are a number of opportunities to defer tax through a corporation. Although corporations will pay tax each year, if you do not require the income personally, you can leave it in the corporation, deferring the personal tax that will be paid until you need it.
Additional financing opportunities
Just like you, a corporation can go to a bank or credit facility and secure debt, however a corporation may also raise capital through issuing shares.
Additional administrative costs
In addition to upfront legal and registration costs, the corporation will be required to file an annual tax return or T2. The costs and additional administrative requirements can be expensive and time consuming.
When your business suffers a loss as a sole proprietorship, that loss can be used to offset or reduce your personal income. When a corporation suffers a loss, it is trapped within the corporation and is not available to offset personal income.
No real limited liability
A common misconception is that the corporation will remove any liability from its owners. However the limited liability is often undercut by personal guarantees and other credit arrangements. Just because you have a corporation doesn’t mean that banks and credit facilities won’t still want a personal guarantee. When you’ve offered a personal guarantee to obtain corporate financing, or any other transaction in the business, you have lost any limited liability from the corporation.
As mentioned, it’s important to realize that there is never a definite yes or no answer to the question as to whether to incorporate or not. It is a decision that requires major consideration, and should not be taken lightly. Often the advantages and disadvantages should be discussed with a professional and the process itself should be undergone under the guidance of both legal and financial advice.
Canadian Controlled Private Corporation (CCPC)As per the CRA website: “For your corporation to be considered a CCPC, it has to meet all of the following requirements at the end of the tax year:
- it is a private corporation;
- it is a corporation that is resident in Canada and was either incorporated in Canada or resident in Canada from June 18, 1971, to the end of the tax year;
- it is not controlled directly or indirectly by one or more non-resident persons;
- it is not controlled directly or indirectly by one or more public corporations (other than a prescribed venture capital corporation, as defined in Regulation 6700 of the Income Tax Regulations);
- it is not controlled by a Canadian resident corporation that lists its shares on a designated stock exchange outside of Canada;
- it is not controlled directly or indirectly by any combination of persons described in the three preceding conditions;
- if all of its shares that are owned by a non-resident person, by a public corporation (other than a prescribed venture capital corporation), or by a corporation with a class of shares listed on a designated stock exchange, were owned by one person, that person would not own sufficient shares to control the corporation; and
- no class of its shares of capital stock is listed on a designated stock exchange.”
Other Private CorporationAs per the CRA website: “To be considered an other private corporation, the corporation has to meet all of the following requirements at the end of the tax year:
- it is resident in Canada;
- it is not a public corporation;
- it is not controlled by one or more public corporations (other than a prescribed venture capital corporation, as defined in Regulation 6700 of the Income Tax Regulations);
- it is not controlled by one or more prescribed federal Crown corporations (as defined in Regulation 7100); and
- it is not controlled by any combination of corporations described in the two previous conditions.”
Public CorporationA public corporation is a corporation which has shares on a public stock exchange. Per the CRA website: “Your corporation is a public corporation if it is resident in Canada and meets either of the following requirements at the end of the tax year:
- it has a class of shares listed on a designated Canadian stock exchange; or
- it has elected, or the Minister of National Revenue has designated it, to be a public corporation and the corporation has complied with prescribed conditions, under Regulation 4800(1) of the Income Tax Regulations, on the number of its shareholders, the dispersing of the ownership of its shares, the public trading of its shares, and the size of the corporation.”
As discussed in other topics, a corporation is a separate legal entity. In order to extract the money or income earned from the corporation, the owners must either receive a dividend or salary from the corporation.
There is truly no correct answer to this question, despite popular belief that one or the other is more beneficial. The CRA has actually developed a theory or system to eliminate any advantage between paying salaries or dividends. Our tax system is designed in a manner that business owners should be indifferent between taking salaries or dividends. This is often referred to as integration.
Our tax system is constantly being revised and tweaked to try and attain integration. In a perfectly integrated tax system, an owner would pay the same amount of tax regardless of whether they were paid salaries or dividends. However our system is not perfect and there are usually opportunities to reduce taxes by adjusting the amount of salaries and bonuses paid. This is often largely attributed to tax rates varying between different provinces. Very careful analysis is required to calculate the mix of salaries and dividends for your corporation’s specific circumstances.
Generally speaking the payment of a salary is deductible to your corporation, while dividends are paid from after-tax corporate profits. Note as a general rule, the CRA does not allow the deduction of salary (or bonuses) without justification. So if the owner is not involved in the business (or their involvement is limited) then providing salaries or bonuses cannot be justified, and will not be deductible. Another consideration for salaries is that you will have to (or get to) make Canadian Pension Plan (CPP) and Employment Insurance (EI contributions). Paying salaries will also allow the owners to be earning income which can increased their allowed participation in Registered Retirement Savings Program (increasing their allowable annual RRSP contribution).
Although dividends will not be deductible by the corporation to reduce corporate tax payable, our integrated system makes up for the lost deduction by reducing the personal tax paid through a dividend tax credit. Basically this is a reduction in the tax paid at the personal level as the income was already taxed at the corporate level. Again, there are a number of considerations that must be analyzed and this is often an excellent opportunity to consult a professional who has the experience and expertise to advise the best strategy.
The small business deduction is a reduction in the tax paid on Active Business Income (ABI) by a Canadian Controlled Private Corporations (CCPC’s). Note that only CCPC’s qualify for the deduction. See the Types of Corporations topic for what defines a CCPC.
Currently the small business deduction reduces the federal tax rate paid on ABI down to 11%. There is a limit on the amount of ABI that qualifies. The current limit is $500,000. Any income above the limit does not qualify.
In addition to the limit on the total qualifying income, larger corporations have a reduction in the allowable ABI. A corporation that has over $10 million in taxable capital (which is basically the assets owned by the company) in the preceding year will see their small business deduction limited. These corporations will see a reduction in the allowable income by $1 for every $10 in taxable capital over the $10 million limit, until they reach $15 million and the small business deduction is completely eliminated.
Also note that CCPC’s must share between associated companies. This is done to prevent taxpayers from simply setting up several companies to increase their allowed small business deduction.
Scientific Research and Experimental Development (SR&ED) is a federal tax incentive program, implemented by the CRA to encourage Canadian businesses to conduct research and development in Canada. The SR&ED program provides cash refunds and/or tax credits for expenditures on eligible R&D work done in Canada.
Corporations, individuals and partners of a partnership can all take advantage of the incentives. It is a common misconception that only large corporations with massive R&D initiatives can participate. Generally, there is a tax credit of at least 15% (and as much as 35% on the first $3 million for CCPC’s) on whatever eligible research and development expenditures you have.
There are some strict rules for the work that is eligible. In order to apply for SR&ED credits, you need to have general information on the research and development being performed, project information, financial information, statistical information, and certifications.
CRA Website – Scientific Research & Experimental Development
- basic groceries such as milk, bread, and vegetables;
- agricultural products such as grain and raw wool;
- prescription drugs and drug-dispensing fees; and
- medical devices such as hearing aids and artificial teeth.
RESOURCESCRA Webstie - GST Video Series
As mentioned, GST/HST is usually collected on behalf of the government by the person or business who is providing the services or goods, and then remitted back to the government. In order to do so, that person or business must be a GST registrant. Although you can volunteer to collect GST, you must collect and remit if your sales exceed the small supplier threshold of $30,000 worldwide taxable supplies or goods sold in either one calendar quarter or four consecutive quarters.
Once registered, you are responsible to collect GST/HST on all taxable goods and services. You must then hold this tax and remit it back to the CRA. In order to remit, you will be required to file a GST return monthly, quarterly or annually depending on your revenues.
Once you have registered, you are also eligible for claiming Input Tax Credits (ITC’s) on all GST you pay. Basically as GST is a consumer tax, GST registrants are allowed to claim ITC’s on the GST paid on services/goods used to provide the goods and services. Thus, your GST return will determine the net GST collected and paid, to be remitted (or refunded if you’ve paid more than you’ve collected). You need to keep accurate records to support your tax obligations and entitlements.
Although you can voluntarily choose to file and remit quarterly or monthly, if you have annual taxable sales and revenues that are $1,500,000 or less, you are only required to file and remit annually. Similarly if your annual taxable sales and revenues are greater than $1,500,000 but either equal or less than $6,000,000 you must at the least file and remit quarterly. If your annuals taxable sales and revenues exceeds $6,000,000 you are required to file and remit monthly.
In addition to the filing requirements, once you are a GST registrant you are also required to provide customers with:
- invoices and/or
Depending on the amount of the sale, if your customers ask you for an invoice or receipt to claim an input tax credit or ITC, depending on the amount of the sale, by law you have to give them certain information.