Under the Income Tax Act (ITA), a business can generally deduct any expenses that are incurred to earn business income, except where specifically prohibited.
Employees, by contrast, are only allowed to deduct expenses that are specifically allowed by the Act. Most of the rules allowing expenses contain various conditions and restrictions.
One condition that applies to many deductible employee expenses is that the employee be “required under the contract of employment” to pay the expenses. Normally, to claim such expenses the employee needs to be able to demonstrate that the employment contract states that the employee is required to incur the costs in question. Generally the employer needs to certify on Form T2200 that this condition is met, as required by Income Tax Act subsection 8(10).
What happens if you own the company, and you are also an employee? Can the company “require” you to incur specific expenses?
In the 2009 Adler decision, the Tax Court of Canada ruled that a sole shareholder was not “required” by his company to incur expenses, even though the employment contract said he was, since there were no consequences to his breaching the agreement. (He was not going to fire himself, for example.)
Although Adler was an Informal Procedure decision, meaning that it’s not legally binding on either the CRA or taxpayers, the CRA decided last year to start applying it. Beginning September 2017, the CRA wrote to many employees who were major or sole shareholders of their companies, and reassessed them to deny employment expenses.
This caused an uproar among small business owners and their advisors, and many complaints were made to the CRA about this interpretation. It would become impossible for any major shareholder to claim these deductions, because they could never prove that the employment contract “required” them to incur the expenses. Numerous taxpayers were planning to appeal this issue to the Tax Court of Canada, but whether they could win was very uncertain.
Fortunately, the CRA has now backed down, will no longer issue these reassessments, and will reverse those already issued. On February 20, 2018, the CRA issued a notice entitled “Employment expenses review”, stating:
“Effective immediately, the Agency will stop reviewing and disallowing ‘other employment expenses’ claimed on line 229 of the T1 ... by shareholder-employees. We will also reverse those reassessments specific to line 229 already issued during the review period Sept. 1, 2017 to Feb. 10, 2018.... Consultation will be undertaken with stakeholders in the tax professional community to clarify the requirement of employer certification under subsection 8(10) ... as it relates to shareholder-employees. It is expected that clarification will be issued to take effect in the 2019 tax year.”
