The Beneficial Section 9 Characterization of Income from a Source (excerpt)

Introduction

In Canada, one of the more important functions of the Income Tax Act[1] (the “Act”), is to serve as a revenue generating tool for the federal government, and therefore, to provide a means for the funding of public expenditures.

Pursuant to the provisions of the Act, the federal government collects revenue in the form of income tax from taxpayers who are ordinarily resident of all Canadian provinces,[2] on the basis of a taxpayer’s source of income.[3]

By way of Definitions section of the Act, a ‘taxpayer’ includes both individuals as well as corporations, regardless of whether they are liable to pay tax.[4]

In 2017-2018, personal income tax accounted for approximately 49% of revenues, with a further approximately 15.2% being derived from corporate income tax.[5] Regardless of which category of income the revenue falls into, revenues collected[6] facilitate public spending on those things that we, as Canadians, have expressed are of importance to us as a society.

In order to be considered income, and therefore subject to taxation, the income must be said to have been derived from a source.[7] Whether the source can be characterized so as to fall into income from office or employment, or income from business or property,[8] is material for the purposes of determining how and when the tax is collected, as well as which deductions may be available to a taxpayer.[9]

As the technological landscape of the world has changed, so too has how a Canadian taxpayer can earn income, which has resulted in what seems to be a perceptibly greater portion of Canadians engaging in contracts for services.

Not all Income is Created Equally

Every man is entitled if he can to order his affairs so as that the tax attaching under the appropriate acts is less than it otherwise would be.[10]

A taxpayer’s characterization of the source of income is one of the ways in which a taxpayer may order his affairs in accordance with the above, and infamous, quote of Lord Tomlin. 

However, it should first be noted that pursuant to the common law, not all monies taken in by a taxpayer in a year are considered income, or therefore subject to taxation.[11] 

To be considered income from a source under any section,[12] the amount should be able to be linked with one or more of the following characteristics:[13]

• recurrence on a periodic basis;
• involving organized effort, activity, or pursuit on the part of the taxpayer;
• giving rise to an enforceable claim to the payment by the taxpayer;
• payment was sought after and/or reasonably expected by the taxpayer;
• the payer is a customary source of income for the taxpayer;
• involving a marketplace exchange; or
• the pursuit of profit.

Once the amounts taken in by the taxpayer have been affirmatively characterized as income from a source, depending on the characterization of the source from which the amounts flowed, the income may fall under different sections of the Act, and therefore lead to the availability of different deductions, remittance time requirements, and possibly even different taxation rates. 

Broadly speaking, sources of income can be characterized in two ways: either as being from office or employment, or as being from business or property. The first step in such characterization requires knowing whether the relationship between the taxpayer and the source is one of a contract of service, which creates an employer-employee relationship, and results in the source of the income being characterized as derived from office or employment, or whether the relationship is one of a contract for services, which creates the relationship of a principal and agent, and results in the source of income being characterized as derived from business or property.

While both characterizations ultimately result in the income being captured by section 3,[14] the way in which the income is characterized, and the corresponding deductions available, may result in different taxpayers reporting different values of their income from a source for the year, even though the gross amounts taken in may have started off as being the same to each of them.

Income from Office or Employment, and the Employee

Pursuant to section 5, income from office or employment is the salary, wages and other remuneration, including gratuities, received by the taxpayer in the year.[15] 

The Act defines “office” as “the position of an individual entitling the individual to a fixed or ascertainable stipend or remuneration”, and “employment” as “the position of an individual in the service of some other person … and “servant” or “employee” means a person holding such a position”.[16] 

When income is characterized as being from office or employment, the taxpayer is categorized as an employee; deductions available for income from office or employment are found in section 8 of the Act.[17] The deductions outlined in section 8 are fairly specific, and are generally of limited applicability to most taxpayers.  Furthermore, deductions allowed under section 8 are also nowhere near as extensive as those deductions provided for elsewhere in the Act. As such, a taxpayer seeking to characterize his income as being from office or employment, as opposed to being from other source characterizations of income, realistically does little to enable himself to reduce his tax burden.

For an employer, the implications of an employer-employee relationship with a taxpayer characterized as an employee is no small matter. Employers are subject to a number of obligations imposed by the Canada Revenue Agency (“CRA”) including the collecting and remitting of various payroll deductions.[18] Among those deductions for which the employer is responsible, is the collecting and remitting the income tax from the remuneration the employer pays to the taxpayer employee in accordance with the applicable Payroll Deductions Table.[19]

Although there is no definitive or conclusive test for determining whether a taxpayer is an employee, and therefore for determining whether or not a taxpayer’s income may be properly characterized as being from office or employment, the courts will consider:[20]

(a)  the degree or absence of control exercised by the employer over the taxpayer;

(b)  ownership of the tools necessary for the work performed by the taxpayer;

(c)  the chance of profit and the risk of loss to the taxpayer; and

(d)  the level of integration of the taxpayer’s work into the would-be-employers business.

The Supreme Court of Canada has noted that the aforementioned factors, often referred to as being those which make up the Wiebe Door test, are not to be taken as an exhaustive list, and that the weight of each factor will depend on the particular facts and circumstances of each case.[21]

However, before a court is ever asked to weigh in on a taxpayer’s employment status or characterization of the source of income, the private law will likely have already made a characterization by way of a contractual arrangement between the taxpayer and the employer, or principal as the case may be.

Given the structure and constraints imposed on a taxpayer who is categorized as an employee, individuals seeking to be categorized as an employee are not typically seeking to do so primarily for the purpose of taxation benefits; rather, individuals will often seek to be employees for the protections afforded to them under the various provincial Employment Standards Acts,[22] and for the benefit of qualifying for Employment Insurance should they become unemployed.[23]

Nevertheless, in 1992, the Federal Court of Appeal said, “[t]here is no foundation in the case law for the proposition that such a[n employment] relationship may exist merely because the parties choose to describe it to be so regardless of the surrounding circumstances when weighted in the light of the Wiebe Door test.”[24]

However, more recent decisions show that the Canadian courts are trending towards giving greater weight to private law agreements made between contracting parties. Beginning as a question regarding the insurability of three ballet dancers for the purposes of the Employment Insurance Act[25] and the Canada Pension Plan[26], in a case indexed as Royal Winnipeg Ballet v. M.N.R.[27], the Court held that, in keeping with other areas of the private law, the parties’ intentions, as reflected in their respective contracts, did hold weight when making a determination regarding their employment relationship. In a series of contracts, the dancers had each agreed with the ballet company that the dancers were self-employed individuals as opposed to employees. Acting consistently with their understanding of being self-employed, the dancers had each registered for their own GST number, charged the ballet company GST for their services, and remitted their own individual taxes accordingly.[28] In agreeing, by way of their respective private law contracts to characterize their employment relationships as those of independent contractors rather than as employees, the source of income of the dancers was therefore characterized as being from business or property, rather than from office or employment. 

While the Royal Winnipeg Ballet decision was not unanimous, the decision has been cited in Canada over 200 times to date, and remains good law.

Income from Business or Property, and the Small Business or Self-Employed Individual

When income is characterized as being from a source of business or property, a taxpayer’s income falls under section 9, with applicable deductions found under section 18 of the Act.[29] Specifically, the Act provides that “income … is the taxpayer’s profit from” business or property.[30] 

The Act defines “business” as including “a profession, calling, trade, manufacture or undertaking of any kind whatever and … an adventure or concern in the nature of trade but does not include an office or employment.”[31]

Further, the Act defines “property” as “property of any kind whatever whether real or personal, immovable or movable, tangible or intangible, or corporeal or incorporeal”.[32]

While definitions found in section 248 of the Act are applicable to all sections of the Act, unless otherwise defined for a particular section, it is important to be mindful of the definition of a taxpayer when determining whether the source of income is from office or employment, or business or property. In particular, when considering whether a taxpayer’s source of income can be said to be from business or property, and so, falling within section 9, as noted above, the Act defines a “taxpayer” as “includ[ing] any person …”, and that a “person” is defined so as to “include any corporation.”[33] Strictly speaking, to conclude that a taxpayer which happens to be a form of corporation could have a source of income from office or employment would be an illogical characterization result, as it is difficult to understand how a form of corporation could satisfy the Wiebe Door test for being an employee. As such, the characterization exercise is practically confined to taxpayers that are pragmatically individuals.

The determination of whether amounts taken in by a taxpayer qualify as income from business or property, may not be as straightforward as the same determination regarding when a source is said to be from office or employment. 

Remembering that not all activities leading to monetary amounts taken in by a taxpayer in a year will be considered income from a source, pursuant to the Supreme Court of Canada, when determining whether a taxpayer’s source of income is from a business or property, first, the general question of whether a source of income even exists must be satisfied in accordance with the characteristics outlined above.[34] At this stage, the inquiry is more focused on what a taxpayer’s activities were that resulted in the amounts being taken in, rather than on whether the amounts received by the taxpayer meet certain and sometimes strict definitions within the Act.

The Tax Court of Canada has provided the following useful guidance for such determinations:

• When a taxpayer’s approach to an activity becomes sufficiently systematic, organized and businesslike with a genuine profit motive so as to constitute rewards (if any) as rewards for effort extended in a commercial context for that purpose, then the activity becomes a business and its incomes and losses are recognized as income or loss sources for the purpose of the Act.[35]

Once the amounts taken in are determined to qualify as income, then the assessment of whether the source of income is from business or property may occur.[36] 

The inquiry then becomes whether the venture was undertaken in a sufficiently commercial manner, whether the predominant intention from the venture was to make a profit, and whether the activity was carried out in accordance with objective businesslike behaviour.[37] 

When determining whether the taxpayer’s subjective intention was to profit from the venture, the court will consider the taxpayer’s profit or loss experienced in the past years, the taxpayer’s training in areas related to the venture, the taxpayer’s intended course of action, and the capability of the venture to show a profit.[38] Effectively, “[i]t is the commercial nature of the taxpayer’s activity which must be evaluated, not his or her business acumen.”[39]

Therefore, even when the relationship would appear on the surface, or to the outside observer, to be one of what is more traditionally thought of as employment, and even though the Canadian courts have said a private law relationship agreed to by the parties does not overthrow the surrounding circumstances,[40] the existence of private law contract for services in conjunction with the taxpayer’s activities will very likely lead to the conclusion that the taxpayer is a form of self-employed worker, whose source of income is derived from business or property, rather than from office or employment. Results of this nature are one of the reasons why it has been said that the Act functions in a complementary way to the private law.[41]

Self-employed workers are frequently referred to, and commonly known, as independent contractors. However, the Act does not provide a definition for an “independent contractor”; in fact, nowhere in the Act does the phrase “independent contractor” appear. Our understanding of what is an independent contractor comes from the private law of tort and contract, and has been explained as it relates to the concept of vicarious liability.[42] 

Individuals who are self-employed often operate as a business of just themselves, sometimes in a completely unstructured way and simply as an unincorporated self-employed individual, or more formally structured as a sole proprietorship, or sometimes as a form of partnership with another self-employed individual. Indeed, many activities, or ventures, that a taxpayer may engage in as a means of generating income, other than entering into a contract of service, are able to be characterized as activities that create income from a business or property source, and therefore, fall within section 9 of the Act.

A taxpayer as an individual, in arranging his means of collecting income in a way that characterizes his income source as falling within section 9 of the Act, and thereby availing himself to the deductions available under section 18,[43] has affected the determination of how his income is taxable, as well as when it must be remitted, and so, is very likely to have been able to order his affairs so as to reduce his tax burden. Accordingly, the characterization of a taxpayer’s source of income as being from business or property is relatively of greater benefit.

For those parties in the position of the principal in the principal and agent relationship, the obligations imposed by CRA when retaining a self-employed individual, over hiring an employee, are far less onerous. When an individual is self-employed, all obligations associated with the remittance of income tax, and any other deductions which would typically occur at source for an employee, falls on the self-employed individual, or agent, rather than on the principal.

While characterization of a taxpayer’s employment relationship has long been a point of contention, as evidenced by the fact that section 9 is one of the most litigated sections of the Act,[44] as taxpayers’ creativity in how to earn income increases, so too does the discussion. It was recommended in 2010 by the House of Commons Standing Committee on Finance that “the federal government examine the [Act] with a view to propose legislative amendments in such a manner that reflects the realities of the modern labour market”.[45]

Encouraging Economic Activity in Canada

Whether intentionally by design, or by means of the application of common accounting practices, section 9, fulfills the very valuable purpose of encouraging taxpayers to engage in activities that promote the growth of the Canadian economy. Without new businesses entering a marketplace, the economy would eventually be made up of only a few increasingly large conglomerates, which may or may not be primarily based in Canada. Pragmatically, taxpayers are unlikely to enter a marketplace unless there is some amount of perceptible benefit, and typically, with the exception of those ventures undertaken to serve purely non-monetary ends, the perceptible benefit includes the realization of a profit.

Section 9 of the Act specifies that it is the taxpayer’s profit, as opposed to simply amounts received by the taxpayer, which are to be included in the taxpayer’s income. By stipulating that the taxpayer’s income is the taxpayer’s profit, the Act allows for deductions of expenses incurred to realize that profit;[46] allowable deductions are specified in section 18. Arguably, without the ability to deduct those expenses reasonably incurred in the course of generating profit from business or property, the cost of starting any new business, or continuing to carry on any small business or sole proprietorship could be cost prohibitive.

No business starts out as a large business; as of December 2017, 97.9% of businesses in Canada were considered to be small businesses, which employed 8.3 million individuals.[47] In the right economic environment, businesses that may have started out as only a self-employed individual can grow into a large enterprise which can then support and spawn even greater economic development. 

Therefore, while legislative amendments may have already been within contemplation in 2010 to address what was then considered to be the modern labour market, it would not be reasonable to infer that such amendments were contemplated to include a marked departure or change to which sources of income fall within section 9 of the Act.

Despite the obviousness of the statement, it is worth noting that greater economic development does ultimately lead to the availability of greater revenues for the government to collect, and subsequently put towards past and future public expenditures. 

[1] An Act Respecting Income Taxes, RSC 1985, c.1. (hereinafter referenced as “The Act”)

[2] The Act, s.250.

[3] The Act, s.3.

[4] The Act, s.248(1).

[5] “Annual Financial Report of the Government of Canada Fiscal Year 2017-2018”, (19 October 2018), Government of Canada, online: <https://www.canada.ca/en/department-finance/services/publications/annual-financial-report/2018/report.html>.

[6] “Annual Financial Report of the Government of Canada Fiscal Year 2017-2018”, (19 October 2018) Government of Canada, online: <https://www.canada.ca/en/department-finance/services/publications/annual-financial-report/2018/report.html>.

[7] The Act, s.3.

[8] The Act, s.5, and s.9, respectively.

[9] The Act, s.8, and s.18, respectively.

[10] Inland Revenue Commissioners v. Duke of Westminster, [1936] A.C. 1 (U.K. H.L.).

[11] Jinyan Li, Joanne Magee, J. Scott Wilkie, Principles of Canadian Income Tax Law 9th Edition (Toronto: Thomson Reuters), at p.109.

[12] The Act, s.4.

[13] Jinyan Li, Joanne Magee, J. Scott Wilkie, Principles of Canadian Income Tax Law 9th Edition (Toronto: Thomson Reuters), at p. 108; Federal Farms Ltd. v. Minister of National Revenue, [1959] Ex. C.R. 91.

[14] The Act, s.3.

[15] The Act, s.5.

[16] The Act, s.248(1).

[17] The Act, s.8.

[18] “What is deducted from your pay?”, (21 July 2020), Government of Canada, online: <https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/payroll/what-deducted-your-pay.html#ncmtx>.

[19] “Employers’ Guide – Payroll Deductions and Remittances”, (4 November 2019), Government of Canada, online: <https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/t4001/employers-guide-payroll-deductions-remittances.html#P293_20565>.

[20] Wiebe Door Services Ltd. v. M.N.R., [1986] F.C.J. No. 1052.

[21] 671122 Ontario Ltd. v. Segaz Industries Canada Inc., 2001 SCC 59.

[22] R.S.B.C. 1996, c. 113; S.O. 2000, c. 41.

[23] An Act respecting employment insurance in Canada, S.C. 1996, c. 23.

[24] M.N.R. v. Standing, [1992] F.C.J. No. 890.

[25] S.C. 1996, c. 23.

[26] R.S.C. 1995, c. C-8.

[27] Royal Winnipeg Ballet v. M.N.R., 2006 FCA 87.

[28] Royal Winnipeg Ballet v. M.N.R., 2006 FCA 87, at para 23.

[29] The Act, s.9, and s.18, respectively.

[30] The Act, s.9(1).

[31] The Act, s.248(1).

[32] The Act, s.248(1).

[33] The Act, s. 248(1).

[34] Stewart v. Canada, 2002 SCC 46; supra, “Not All Income is Create Equally”.

[35] Spearing v. R., [2001] T.C.J. No. 32, at para 22.

[36] Stewart v. Canada, 2002 SCC 46.

[37] Stewart v. Canada, 2002 SCC 46.

[38] Moldowan v. Canada, [1978] 1 S.C.R. 480.

[39] Moldowan v. Canada, [1978] 1 S.C.R. 480.

[40] David G. Duff, et al., Canadian Income Tax Law 5th Edition (Markham: LexisNexis, 2015), at p. 209.

[41] David G. Duff, The Federal Income Tax Act and Private Law in Canada, Canadian Tax Journal, 2003, Vol 51, No 1.

[42] 671122 Ontario Ltd. v. Sagaz Industries Canada Inc., 2001 SCC 59; London Drugs Ltd. v. Kuehne & Nagel International Ltd., [1992] 3 S.C.R. 299.

[43] The Act, s.18.

[44] Jinyan Li, Joanne Magee, J. Scott Wilkie, Principles of Canadian Income Tax Law 9th Edition (Toronto: Thomson Reuters), at p. 162.

[45] David G. Duff, et al., Canadian Income Tax Law 5th Edition (Markham: LexisNexis, 2015), at p. 236; James Rajotte, “Servant or Master?”, House of Commons Standing Committee on Finance, (40th Parliament, 3rd Session, June 2010).

[46] David G. Duff, et al., Canadian Income Tax Law 5th Edition (Markham: LexisNexis, 2015), at p. 619; “Business Expenses”, (12 February 2019), Government of Canada, online: <https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/sole-proprietorships-partnerships/business-expenses.html>; “A Simple Guide to Tax Deductible Business Expenses”, Business Development Canada, online: <https://www.bdc.ca/en/articles-tools/money-finance/manage-finances/pages/tax-deductible-expenses.aspx>.

[47] “Key Small Business Statistics – January 2019”, (6 December 2019), Government of Canada, online: <https://www.ic.gc.ca/eic/site/061.nsf/eng/h_03090.html>.