On August 1, 2012, the Supreme Court of Canada released its unanimous decision in Canada v. Craig, 2012 SCC 43. This case, which involves the deductibility of farm losses under subsection 31(1), is a significant departure from Moldowan v. R.,  1 S.C.R. 480, in which the Supreme Court had adopted a restrictive approach to the deduction of farm losses.
A loss from farming is not deductible for income tax purposes if the farm loss limitation rule in subsection 31(1) of the Income Tax Act (Canada) applies. In general terms, this rule provides that, where a taxpayer’s chief source of income for a taxation year is neither farming nor a combination of farming and some other source of income (referred to as the “combination exception”), the taxpayer’s deductible farm loss is limited to $8,750 annually.
In Moldowan, the Supreme Court had held that the farm loss limitation rule was applicable to taxpayers who do not look to farming, or to farming and some subordinate source of income, for their livelihood but who carry on farming as a sideline business. As a practical matter, this ruling had the effect of disregarding the combination exception in subsection 31(1). Consequently, if farming was a subordinate source of income or a sideline business of a taxpayer, the farm loss limitation rule would apply without exception. Thus, the only way to ensure that the farm loss limitation rule would not apply was to have farming has a “chief source of income”, thereby rendering the combination exception in subsection 31(1) meaningless.
In Craig, the taxpayer was a lawyer whose primary source of income was derived from his law practice. In addition, the taxpayer was in the horse-racing business. Although this business had been profitable for a few years, it realized losses in 2000 and 2001. The taxpayer deducted these losses from his other income. Relying on subsection 31(1), as interpreted by Moldowan, the Minister limited the losses of the taxpayer for each year to $8,750, on the basis that the horse-racing business was a subordinate source of income or a sideline business. Both the Tax Court of Canada and the Federal Court of Appeal did not follow Moldowan and held in favour of the taxpayer.
The main issue dealt with by the Supreme Court was whether Moldowan should be overruled. However, before addressing this issue, the Supreme Court commented on the fact that the lower courts did not follow Moldowan. Justice Rothstein, who wrote the decision on behalf of the Supreme Court, stated that Moldowan was a precedent binding on the Tax Court and the Federal Court of Appeal. Therefore, rather than purporting to overrule Moldowan, the lower courts should have written reasons as to why Moldowan was problematic.
Justice Rothstein then turned to whether Moldowan should be overruled. While recognizing that courts must proceed with caution when deciding to overrule a prior decision, Justice Rothstein was of the opinion that relevant considerations justified overruling Moldowan (e.g., Moldowan reads the combination exception out of subsection 31(1) and has been the subject of criticism since its issuance in 1977). That being the case, Justice Rothstein concluded that the Moldowan approach to the combination exception was incorrect and that it was appropriate to revisit this aspect of section 31.
Approaching the combination exception afresh, Justice Rothstein held that a simple aggregation of income from two sources cannot have been contemplated by section 31 and that other factors must also be taken into account. These factors include the capital invested in farming and the second source of income, the income from each of the two sources of income, the time spent on the two sources of income, and the taxpayer’s ordinary mode of living, farming history, and future intentions and expectations. If these factors demonstrate that the taxpayer places significant emphasis on both the farming and non-farming sources of income, such a combination should constitute a “chief source of income”, thereby avoiding the application of the farm loss limitation rule in subsection 31(1).
Significantly, Justice Rothstein emphasized that in order to meet the combination exception, there is no requirement that the two sources of income be connected or that farming be the predominant source of income when viewed in combination with another source. Instead, the question is whether, looking at the above factors together, the taxpayer places significant emphasis on each of the farming business and other earning activity. If so, the combination will constitute a chief source of income and avoid the farm loss limitation rule in subsection 31(1).
After formulating the above principles, Justice Rothstein held that there was no basis to disturb the Tax Court’s findings that farming, in combination with the taxpayer’s law practice, was a chief source of income, and that the farm loss limitation rule in subsection 31(1) did not apply.
Based on the foregoing, it follows that the new, broader interpretation of the combination exception adopted by the Supreme Court in Craig will undoubtedly facilitate the deduction of certain farm losses that would otherwise have been denied under Moldowan. As such, it is expected that the Craig decision will be welcomed by taxpayers and tax practitioners alike, who, over three decades prior to Craig, had criticized Moldowan for its restrictive interpretation of the combination exception in subsection 31(1). Taxpayers who had previously been challenged by the CRA as a result of Moldowan should also consider revisiting the issue in light of the guidance provided in Craig.