One of the ways a business can reduce its taxes is by maximizing tax deductions. Business owners are inherently motivated to claim as many expenses as possible to minimize their taxes. However, this could be risky if some of the expenses are not legitimate. If the CRA discovers an error, the business will be charged with penalties and interest. It will also be more proned to audits in the future, and repeat offenders will face more serious consequences. To ensure all claims are legitimate, you need to to understand the criteria to deduct business expenses. Here we will go over the 4 criteria used by the CRA.
The first criteria is the business expense must be reasonable. This could be tricky because a reasonable business expense for one business might not be considered reasonable for another business. It depends on the industry and the context of the expense. For example, if you are in the business of selling widgets, you may be spending more on technology and product development. Whereas if you are running a restaurant, it’s probably not reasonable to spend an excessive amount on this type of expense. You would likely be spending more on food ingredients and even cleaning services to ensure it passes the health inspection test.
Another point to keep in mind on reasonableness is the size of the expense relative to the overall business revenue. Say if your business makes $100,000 and you are claiming $40,000 for meals and entertainment. 40% alone in one category is possible, but probably not reasonable in most situations.
The second criteria is whether the expense is incurred for the purpose of earning business income. It is important to note that money spent doesn’t necessarily need to translate into revenue. You could be spending marketing dollars to build brand awareness for the company, and it’ll be fully deductible as long as the purpose is to earn business income.
One common mistakes that many business owners make is claiming personal expenses as deduction. Even if you use business funds to pay for personal expenses, you are still not eligible to make the claim. If the business is audited by the CRA, it will be liable for the tax otherwise owed, plus penalties and interest. In addition, mixing personal with business transactions will create complications for accounting records, thus increasing the time and costs required for bookkeeping. Best practice is to keep personal and business transactions separate and only use business accounts for expenses that are related to the business.
Proper supporting documents
The third criteria that most owners are aware of is to maintain proper supporting documentation for all business expenses. You’ll need proper bookkeeping done in an accounting system and maintain all receipts and invoices to support the tax deduction. Here’s a general rule of thumb: If you don’t have records of receipts or purchase invoices, then you cannot claim the expense.
For businesses that are just starting out, it is acceptable to use a manual system for tracking paper copies of receipts and invoices. However, it’s best to leverage technology and use a paperless record keeping system to maintain digital records of all supporting documents. You will be more organized and efficient with all records being stored in the cloud in one central location.
Also, remember that the business is required by law to keep complete records for 6 years after the company’s tax return is filed. The CRA can conduct an audit on the business at anytime so it’s best to invest in a reliable cloud accounting solution like Quickbooks Online.
Current expense vs capital expenditure
The final criteria is ensuring the amount claimed is a current expense and not a capital expenditure. Current expenses are purchases that will be consumed within the same fiscal year and capital expenditures are purchases that will benefit the business beyond the current fiscal year. Say you bought a laptop for $2,000 and will be used for the next 3 years. The purchase is considered a capital expenditure because the business will continue to use it over the next 3 years. Your business cannot claimed the entire amount as expense in the year of purchase but instead, the asset must be depreciated. If an error is made in categorizing expenses, the business will be financially liable for additional taxes plus penalties and interest.