A farmer who loses money in his farming business may be stopped from deducting some farm losses from other sources of income. These non-deductible farm losses are called “Restricted Farm Losses” and can only be deducted from farming income. Basically, the Restricted Farm Loss provisions of the Income Tax Act in Section 31 [formerly Section 13(1)] are intended to stop people “who earn their income in the city and lose it in the country” Robertson, JJ.A. in The Queen v Donnelly FCA
The restricted farm loss legislation limits the farm loss that can be claimed in the year it occurs to $2,500 plus ½ of the next $12,500 of losses, or a maximum of $8,750 (for years after 1994). Any loss in excess of this amount can be carried forward 20 years or back 3 years, but can only be applied against farming income.
Because of the nature of many farms, mostly the length of time it may take for a farm to become profitable, it was quite difficult for an auditor to show that the farmer did not have a reasonable expectation of profit in the past. Therefore, CRA auditors would often settle for restricting the farm loss, rather than trying to support denying it entirely. New legislation was proposed, and then withdrawn, that would have required a taxpayer to show that they had a reasonable expectation of profit in any year that they have a loss before they could deduct the loss. The Department of Finance has indicated that it will be introducing revised legislation at some point in the future.
The definitive court case regarding restricted farm losses is Moldowan v The Queen  1 S.C.R. 480. Moldowan has been Canada Revenue Agency’s (CRA) basis for denying losses to many taxpayers, not just farmers, or restricting farm losses for taxpayers engaged in farming. In Moldowan, the Supreme Court said:
“In my opinion, the Income Tax Act as a whole envisages three classes of farmers:
- a taxpayer, for whom farming may reasonably be expected to provide the bulk of income or the centre of work routine. Such a taxpayer, who looks to farming for his livelihood, is free of the limitation of s.13(1) in those years in which he sustains a farming loss.
- the taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood but carried on farming as a sideline business. Such a taxpayer is entitled to the deductions spelled out in s.13(1) in respect of farming losses.
- the taxpayer who does not look to farming, or to farming and some subordinate source of income, for his livelihood and who carried on some farming activities as a hobby. The losses sustained by such a taxpayer on his non-business farming are not deductible in any amount.
The reference in s.13(1) to a taxpayer whose source of income is a combination of farming and some other source of income is a reference to class (1). It contemplates a man whose major preoccupation is farming. But it recognizes that such a man may have other pecuniary interests as well, such as income from investments, or income from a sideline employment or business. The section provides that these subsidiary interests will not place the taxpayer in class (2) and thereby limit the deductibility of any loss which may be suffered to $5,000.”
The Supreme Court in Moldowan v. The Queen went on to conclude that a farmer had to have a Reasonable Expectation of Profit (REOP) in order to qualify as either Class (1) or Class (2), and that if there was no reasonable expectation of profit, no loss could be deducted at all.
This court decision has been used by auditors for many years to deny losses from businesses and investments in general, including rental properties. Recently (2002) two court cases by the Supreme Court restricted the ability of CRA to use REOP to deny losses for businesses and property. In apparent response to the rulings in Stewart v. Canada (2002, SCC 46) and Walls v. Canada (2002, SCC 47), the government introduced legislation on October 31, 2003 proposing to amend the Income Tax Act to deny any loss that does not have a reasonable expectation of profit, as defined in the new legislation.
This legislation has since been withdrawn after vigorous opposition by various organizations, but the Department of Finance has indicated that it will be introducing revised legislation at some point in the future.