The demographics of Canada’s professional community are changing rapidly. In law and medicine, women make up - and have done so for 10 years - about 65 per cent of first-year classes.
Senior male members of both professions are quickly approaching retirement. The demographic landscape by the end of this decade requires fresh thinking of basic tax principles.
A fundamental principle of tax law is that an expense is deductible only if someone incurs it to earn income. The purpose of the rule is to obtain an accurate measure of net income. Personal and consumption expenditures are not deductible unless the Income Tax Act specifically authorizes their deduction.
Hence, the line that divides deductible and non-deductible expenses should provide an accurate and fair measure of income based upon principles that the authorities can administer with certainty.
Some expenses are clearly of a purely business nature, meaning there is no serious issue of their deductibility. For example, business salaries, rent, utilities, and operating costs are deductible (subject only to quantum limitations) as routine expenses without the need for specific authorization.
At the other end of the continuum, we find expenses of a purely personal nature. For example, a taxpayer isn’t entitled to deduct everyday costs for personal meals, clothing, cosmetics, and grooming.
As in most tax law, however, the difficult distinctions lie not at the extremes of the continuum but in the middle where the expenditure has both business and personal attributes. It is here that we look at the primary and predominant purpose of the expenditure.
We can break down grey-zone expenditures into two broad categories: first, the hybrid costs of a person engaged in business, such as childcare and commuting; and personal-gratification costs that give pleasure in the pursuit of profit, such as meals, travel, and entertainment.
Tax law deals quite clearly with both categories of expenditures for employees. Employees cannot deduct any expenses from income unless the statute specifically authorizes the deduction.
Thus, in effect, we tax employees on their gross income. This rule emphasizes preserving the tax base. Withholding payroll taxes at source is easy. Employment source deductions provide a stable and predictable flow of revenue.
The problem is more difficult, however, for business expenditures, where the rule is the opposite. A taxpayer can deduct any expense incurred for earning profit unless the act specifically prohibits the deduction.
Thus, people generally prefer independent contractor status for tax purposes because they have greater flexibility with business deductions. Conversely, they prefer to be employees under labour laws because they get greater workplace protection.
We decide the purpose of an expenditure by determining the predominant reason for incurring it. This is a positive test that’s quite different from asking the opposite question: “What would have happened if the taxpayer hadn’t incurred the expense?” Thus, the purpose test is different from the “but for” test that asks: “But for this expense, could the taxpayer have earned the income?” But that test is too broad and one that completely obliterates the distinction between business and personal expenses.
Hybrid expenditures are expenses incurred partly for profit and partly for personal consumption. Childcare expenses are the classic hybrid. Parents with infant children can’t go out to work without care for them.
The courts, however, don’t allow childcare as business expenses on the theory that their deduction would open the floodgates to doing so for all sorts of other personal expenses.
The U.S. board of tax appeals captured the prevailing sentiment in a 1939 American case: “The fee to the doctor, but for whose healing service the earner of the family income could not leave his sickbed; the cost of the labourer’s raiment, for how can the world proceed about its business unclothed; the very home which gives us shelter and rest; and the food which provides energy, might all by an extension of the same proposition be construed as necessary to the operation of business and to the creation of income.
Yet these are the very essence of those ‘personal’ expenses, the deductibility of which is expressly denied.”
Pre-war America expected women to stay at home and look after their children. Thus, courts didn’t look for the predominant purpose of women working in business. Within the next decade, women in the legal and medical professions will outnumber an aging male population that is coming up to retirement age.
There is an important distinction between expenses incurred primarily for personal purposes and expenses incurred predominantly for earning income but that have incidental and ancillary personal elements. Certain expenditures are clearly common to everyone.
The basic personal expenditures for food, shelter, clothing, and the everyday necessities of life are clearly not deductible regardless of working status. People don’t incur such expenses primarily for the purposes of earning income.
Childcare expenses, however, pose a different conceptual problem. If we start with the premise that one parent must stay at home to look after the child, childcare expenses are primarily a personal consumption expenditure.
Yet if we start with the opposite premise that it’s necessary or desirable for both parents to work, childcare expenses take on a different hue. Thus, the perspective on childcare expenses depends upon where the analysis begins.
The deductibility of such expenses also raises issues of fairness if some taxpayers can get tax-free childcare while we deny others the same treatment. An employer, for example, is entitled to deduct the cost of childcare that it provides at its facilities.
The expenses are for the purposes of earning business income. Parents with young children who are being well-cared for on the employer’s premises are likely to work longer and with less anxiety than parents who need to dash off in a frenzy to pick up their kids at a specific time.
Since the employer needs the services of its employees, the cost of providing childcare on its premises directly relates to them.
We can say the same of nanny care. The inequity arises because a person who pays for childcare services to get to work is severely limited in deducting those costs.
We sometimes explain this disparity on the basis that the employer incurs its cost after its employees are on the business premises while parents incur their expenses to get to work in the first place. This invites salary arbitrage.
Tax law must keep up with social and demographic changes if it is to be socially relevant and economically productive. It’s time to legislate a principled solution for tomorrow’s society.
Professor Vern Krishna is tax counsel with Borden Ladner Gervais LLP and executive director of the CGA Tax Research Centre at the University of Ottawa. He can be reached at [email protected]
