Whether an activity is a business or a hobby can be a thorny issue and have important tax implications. Many clients ask "Why worry about it – it’s all taxable anyway…isn’t it?" No, if an activity is a hobby, it is not taxable. Do I have your interest now?

What Revenue Canada and the courts look at is whether there is an intention to earn a profit and there is a "reasonable expectation of profit". When you think about this wording, you can see why there is so much debate about the interpretation of "intention" and "reasonable expectation". Also, both have to be present. Sometimes people really try to earn a profit but, in reality, there is no reasonable expectation of a profit.

So…what does Revenue Canada mean by intention to earn a profit? Revenue Canada looks at the conduct of the owner such as professionalism, advertising, records kept and how much time and effort is put into the activity. Revenue Canada also looks at the nature of the activity. For example, if you create crafts for the Christmas season that you sell to family and friends at a price to cover your costs, there is a good chance it will be considered a hobby. If you attend craft fairs and/or advertise and sell a large variety of products, chances are you will be considered a business. Also be aware that there are situations where a hobby grows to such an extent that it becomes a business for tax purposes.

Reasonable expectation of profit is partially based on actual profit and loss experience over the years. This can be a hotly contested issue between the individual and Revenue Canada. Some expenses an individual thinks should be allowed Revenue Canada may not allow and thus it creates more of an expectation of profit and can move the activity from a hobby to a business in Revenue Canada’s eyes. Other things that Revenue Canada looks at are the experience and interest of the individual and how much effort is made to sell the products.

Activities that Revenue Canada looks at more closely to determine if they are a hobby or a business includes farmers with off farm employment income, artists, musicians, home-based businesses, people who are direct selling, photography, gambling and gardening. The idea of a hobby is one of the main reasons gambling winnings are not taxable. If a person starts devoting a large amount of time to gambling and is actually experiencing profits, it may be considered a business.

Many people starting up in business experience losses for a period of time (this does NOT have to happen, though) and think they cannot claim these losses against other sources of income. Revenue Canada realizes how tough it can be to start a business and, especially when the business is the sole source of income, will allow losses for as much as five years. Revenue Canada will look more closely if there are other sources of income. An excellent example is a surgeon in Ontario who claimed farm losses for his horses. Revenue Canada said no way especially considering his medical practice required a vast majority of his time and, at $500,000 a year, was the major source of income for him. As far as Revenue Canada was concerned, the horses were a hobby with no intention or reasonable expectation of a profit.

There is an extra twist to all this. Lets look at the following situation. You have a hobby of painting landscapes on weekends during the summer. Someone comes along and is absolutely enthralled with one of your paintings and offers you $1,500 for it. Wow! A dream come true - $1,500 and it is all yours. Wait a minute, though. Almost anything you sell related to a hobby activity for more than $1,000 can become subject to a capital gains tax as a personal-use property. Yes, Revenue Canada gets you coming and going.

A note about keeping records. Some people fall under the illusion that if they don’t keep a record of a sale, Revenue Canada will never know about it. Remember that Revenue Canada has a whole lot more experience at sniffing out "underground" activity than any individual will ever have at hiding income. Some people do get pretty good at hiding money but then Revenue Canada can turn around and do a net worth assessment. In these situations, Revenue Canada can make sweeping assumptions that you then have to try and prove wrong. Pretty hard to do if you do not have any records.

This article is provided for information purposes only and should be used only in conjunction with the appropriate advice about your specific situation from an appropriate professional.