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Section 31 of the Income Tax Act – Moldowan Overruled!

It’s been just over four months since the Supreme Court of Canada (the “SCC”) heard oral argument in The Queen v. John H. Craig (see our prior blog post for coverage of the hearing and background on section 31), the only section 31 restricted farm loss case to reach the SCC since the oft-criticized Moldowan v. R., 1977 DTC 5213.

Result: Moldowan has been overruled. It took an uncharacteristically short period of time for the SCC to render its judgment – the unanimous decision emphatically stated that “Moldowan cannot stand.”

Justice Rothstein delivered the reasons, which prescribe a new analysis to be undertaken when a taxpayer needs to determine if his or her income from farming activities (such as a horse racing or breeding business), when combined with some other source of income (such as employment or business income) constitutes a “chief source of income.” If this test is satisfied, then the taxpayer may deduct the full amount of any losses from the farming operation against the other source of income, without restriction. If the test is not satisfied, then section 31 restricts the amount of the deductible loss in any given taxation year to $8,750.

The New Test: The new test outlined by the SCC is still a fact-based analysis to be applied to the particular circumstances of the taxpayer, and has two steps:

Step 1: At the outset, a determination needs to be made that the farming business is in fact a business (a source of income from which losses may be deducted), as opposed to a personal endeavour. This test is enunciated in Stewart v. Canada (2002 SCC 46) as the “commercial manner” test, stating that the farming operation is a business if there is no personal or hobby element; or if there is a personal or hobby element, then the venture must be undertaken in a sufficiently commercial manner “in accordance with objective standards of businesslike behaviour” in order to be considered a business.

Step 2: Once it is determined that the farming operation is a business, the taxpayer is entitled to full deduction of farming losses against another source of income if it is determined that farming and the other source of income is his or her chief source of income, based on the following factors, taken together: the amount of capital invested in farming and the other source of income; the income from each of the two sources of income; the time spent on the two sources of income; and the taxpayer’s ordinary mode of living, farming history and future intentions and expectations. To be successful, it must be shown that the taxpayer has invested significant funds and has spent considerable time attending to the farming business and that the taxpayer places significant emphasis on both the farming and non-farming sources of income. Further, it is not necessary that income from the farming business exceed income from the other source of income – this fact is irrelevant to the analysis.

The new test could be described as the “significant endeavors” test – which is much more palatable than the defunct ‘reasonable expectation of profit’ test or ‘three classes of farmer’ test that has now been buried along with Moldowan. RIP.

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Section 31 of the Income Tax Act – Moldowan Overruled!

The cards are on the table – Supreme Court of Canada hears argument on whether to confirm or overrule Moldowan

Were your ears ringing this morning? They might have been if you are a racehorse owner or breeder in Canada, or if you are any other type of farmer who earns income from farming and some other source of income and are thus subject to section 31 of the Income Tax Act (the “Act”).

Section 31 of the Act is the restricted farm loss rule that operates to restrict the deductibility of your full farming losses against other sources of income if farming or a combination of farming and some other source of income is not your “chief source of income.”

For the past 35 years, section 31 has been applied to taxpayers on the basis of the Supreme Court of Canada’s decision in Moldowan v. R., 1977 DTC 5213 (S.C.C.), which has resulted in section 31 being one of the most litigated provisions of the Act and replete with confusion, ambiguity and inconsistent results. Finally, the Supreme Court of Canada granted leave in The Queen v. John R. Craig, which was heard this morning by a seven judge panel (Chief Justice McLachlin and Justice Fish were absent). For our earlier blog post on the case (including the factum filed by each party), click here.

The argument took two hours to complete. In the first hour the Court heard argument from counsel representing the Canada Revenue Agency (“Crown Counsel”), which was divided equally into two distinct sets of submissions organized by issue, and argued in succession by two Department of Justice lawyers.

The first issue addressed by Crown Counsel was its assertion that the legal doctrine of stare decisis was misapplied by the Federal Court of Appeal when it decided Craig, which, in the Crown’s submission, suggested that if Moldowan was applied in the manner desired by the Crown, then the case should have ended there with a Crown victory. Madam Justice Abella and Mr. Justice Rothstein took charge of this issue and put Crown Counsel to task with several related questions.

Justice Abella was very active in her questioning and emphasized that the evolution of the principles of statutory interpretation over the course of time makes it appropriate for outdated concepts to be reviewed. Further, the Supreme Court of Canada is THE venue for addressing any inconsistencies and is charged with the task of adjusting the principles for future application if the updated approach yields a different outcome.

It was also emphasized by both Justice Abella and Justice Rothstein that it is appropriate for lower courts to indicate that there is a problem with a prior precedent or an approach to interpretation, since that is the only way the record can be built and the matter brought before the Supreme Court of Canada for final resolution. That’s why they are there.

It was also noteworthy that Crown Counsel stated that the main issue to be decided was stare decisis, whereas Justice Rothstein was clear in his comments that the Supreme Court of Canada is free to overrule itself, and emphasized to Crown Counsel that the real question is whether Moldowan is right or wrong in the face of so much judicial and academic criticism. Those are the submissions he wanted to hear.

The second half of Crown Counsel’s submissions focused on the assertion that the Moldowan analysis of section 31 is correct and should not be disturbed.

Other tidbits from the panel during Crown Counsel’s submissions was Mr. Justice Moldaver’s comment that the ‘government is quite happy with Moldowan’ and Justice Abella’s comment that ‘farming is inherently unreliable as a source of income’ emphasizing the complexity of dealing with farming in the context of tax law. Justices LeBel, Karakatsanis and Cromwell also engaged Crown Counsel with questions during argument.

Mr. Craig’s counsel (“Taxpayer Counsel”) spent his hour focusing on Moldowan and why it needs to be overruled, given current principles of statutory interpretation, its unfairness to taxpayers and emphasizing the better approach taken by the Federal Court of Appeal in Gunn v. R., 2006 DTC 6544 (F.C.A.), which was followed by the Federal Court of Appeal in Craig. Further, it was submitted by Taxpayer Counsel that Mr. Craig would be successful with respect to the section 31 issue even upon strict application of the Moldowan principles.

The Justices were quite engaged in this discussion, which elicited questions or comments from Justices Abella, Moldaver, Cromwell, Karakatsanis, Deschamps and LeBel, all primarily directed at the wording of section 31 and how sense can be made of its wording to create fairness and certainty.

Taxpayer Counsel spent very little time on the stare decisis issue on the basis that, in its submission, the real issue is the correct interpretation of section 31.

After exactly two hours of argument, the far reaching financial implications on racehorse owners, breeders and other part-time farmers is now in the hands of the highest Court in the land to determine the future application of section 31, once and for all. The judgment is expected to be rendered within the next six to twelve months. Stay tuned.

For further background on this issue and a more comprehensive analysis of the history of section 31 prior to the appeal of Craig to the Supreme Court of Canada, click here.

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The cards are on the table – Supreme Court of Canada hears argument on whether to confirm or overrule Moldowan

Is Moldowan Still Good Law? The Queen v. John H. Craig

On March 23, 2012, the Supreme Court of Canada is tentatively scheduled to hear the Crown’s appeal in The Queen v. John H. Craig.  The Court will have an opportunity to reconsider its 1978 decision (Moldowan v. The Queen, [1978] 1 S.C.R. 480) which has been relied on in almost every farm loss case since then.

While earning most of his income in his 2000 and 2001 taxation years as a partner of a law firm, Mr. Craig also had income from a business comprising the buying, selling, breeding, and racing of horses.  The Minister disallowed the losses deducted by Mr. Craig in those years in respect of the horse business.

Relying on subsection 31(1) of the Income Tax Act, which restricts farm losses in instances where a taxpayer’s “chief source of income” for a taxation year is neither farming nor a combination of farming and some other source of income, the Minister restricted Mr. Craig’s allowable deductions from the horse business to $8,750 for each year on the basis that his other income was not subordinate to his farming income.

Mr. Craig appealed the Minister’s reassessments.  The Tax Court of Canada allowed Mr. Craig’s appeals, and the Federal Court of Appeal dismissed the Minister’s appeal.

The questions to be addressed in this appeal include the following:

(a) Whether the test to determine whether farming is a “chief source of income” under subsection 31(1) of the Income Tax Act continues to be the test described in the decision of the Supreme Court of Canada in Moldowan.

(b) Whether an appellate court is bound by a previous decision of that appellate court when it is inconsistent with a prior decision of the Supreme Court of Canada.

For the appellant’s written submissions, see the factum of the Crown.

For the respondent’s written submissions, see the factum of Mr. Craig.

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Is Moldowan Still Good Law? The Queen v. John H. Craig