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Home Office Expenses:
Many business owners claim a portion of their residential expenses as business expenses, only to have the claim denied at audit pursuant to subsection 18(12) of the ITA.
The expense may be denied even though it is pretty obvious that the home is being used for business purposes. Putting the issue of the quantum claimed aside, the denied expense can sometimes be reinstated for future years by making a small change in the use of the residence.
Sometimes the client does not need to change anything; the nature of the business just needs to be explained better.
Subsection 18(12) of the ITA has two independent tests, but in my opinion, the CRA’s interpretation of the subsection results in only one of the tests being applicable.
1. Under paragraph 18(12)(a)(i) residential expenses are deductible if the "in-home" workspace is the taxpayer’s principal place of business.
2. Under paragraph 18(12)(a)(ii) residential expenses are deductible if the "in-home" workspace is used exclusively to earn income and is used regularly and continuously to meet clients.
Denials usually happen under paragraph 18(12)(a)(ii). On more than one occasion I have seen the denial of home office expenses on the basis that the "in-home" work space was cobbled together in a spare bedroom, laundry room or playroom.
Space is, therefore, not used exclusively to earn income and meet clients. The requirement of an exclusive works space makes compliance difficult for many people.
The test under paragraph 18(12)(a)(ii) is further denuded by the phrase “regularly and continuously.”
IT 514 provides this example to explain the phrase:
A home office used by a doctor to meet one or two patients a week is an example of a workspace that would not be considered used on a regular and continuous basis for meeting patients.
On the other hand, a workspace used to meet an average of 5 patients a day for 5 days each week would clearly be used for that purpose on a regular and continuous basis.
Also notes that the word “principal” is not defined in the ITA but it is considered that the words “chief” and “main” are synonymous to it.
I doubt that there are many professionals that meet 5 clients a day for 5 days each week in anything other than their principal place of business.
It is this CRA requirement that makes paragraph 18(12)(a)(ii) largely irrelevant. As noted above, my experience is that clients are usually denied the expense under paragraph18(12)(a)(ii).
These same clients have probably not even considered whether they might fit under the test in paragraph 18(12)(a)(i).
A common assumption is that the “principal place of business” is the place where revenue is generated.
For the 18(12)(a)(i) test, the CRA acknowledges the workspace does not need to be used exclusively for business purposes. IT 514 also provides examples of businesses that qualify under the test.
1. A principal place of business would include a room in a contractor's residence used to accomplish the functions relating to a contracting business, such as receiving work orders, bookkeeping, purchasing and preparing payrolls while the remaining activities of the business, the performance of the contracts, are carried out at the customers location.
2. The work space in a farmer's home utilized to operate the farming business would normally be the farmer's principal place of business.
In both examples, the “income generating activity” is somewhere other than the taxpayer’s residence.
In Jenkins.R.109the Crown argued that “business” meant a calling, trade, manufacture or undertaking and that a principal place of business means the core aspect of the business. Jenkins, the Appellant was a fisher.
This meant that the principal place of business would be out on the ocean where fish were harvested.
Miller J. rejected the Crown’s approach, pointing out the following:
This approach leaves to some odd conclusions. For example, the principal place of Imperial Oil would be the oilfield and not it's downtown Calgary head office;
the principal place of business of a farmer might be the combine and not the farmhouse. I could go on.
The other flaw in this approach is that it leads to the possibility of numerous places of business, with a dilemma of how to determine which is the principal place of business. So, if Mr. and Mrs. Jenkins had half a dozen boats, all out at sea throughout the season, are they all “places of business”?
Is one of them the “principal place of business”? Is that dependent on the number of fish caught?This quickly deteriorates into an awkward analysis.
Miller J. finds that the “principal place of business” is better understood to mean the following. “where all that business stuff takes place”; not where the oil is drilled or crop is cut, or fish are fished, but where those necessary elements of telephoning customers and suppliers, filling in invoices, doing payroll, maintaining books and records, contacting authorities for licences, preparing tax returns, chasing down receivables, handling complaints, creating business plans, preparing financial statements, talking to accountants and lawyers,etc.
While only the rare client will qualify under the 18(12)(a)(ii) test, most clients operating businesses from their homes should qualify under paragraph 18(12)(a)(i).
Home Office Expense Checklist
The following items might useful in an audit of home office expenses.
Is the expense going to be denied under paragraph 18(12)(a)(ii)? Does the client do their business planning and bookkeeping at home? Perhaps the client fits under paragraph18(12)(a)(i).
Is the client claiming all of the relevant expenses relatedto the home office?1133. Section 18(12) cannot be used to create a loss. Subsection 18(12) applies to limit expenses on business income incurred by individuals.Income from property or income earned bya corporation should not be limited by the subsection.
The expenses should be apportioned between business and non-business use on a reasonable basis, such assquare meters of floor space used.
Claiming CCA on the residence is a risky strategy. The residence may be deemed to undergo a change in use and lose its status as a principal residence..
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