BUSINESS EXPENSES and CAPITAL COST ALLOWANCE

Introduction:

This document is intended for persons assisting low-income self-employed individuals in Ontario.

Background:

The Income Tax Act requires a person to report “business” income, and in particular “profit from that business”, or alternatively a business may have a “loss”.^[1]

The Income Tax Act does not define profit but it’s understood to mean gross income less deductions for business expenses, resulting in a net self-employment income.^[2] The gross and net income amounts are reported on lines 13499 and 13500 of a T1 Tax return.^[3] 

Gross income, deductions, and net income are calculated using a T2125 form. Tax prep software will complete a T2125 form based on information provided.^[4]

The Income Tax Act doesn’t have a closed list of what deductions are allowed. But it does contain general principles along with some specific rules for some types of expenses.

Core general principles: To qualify as a deductible business expense it must:

• be made or incurred for the purpose of gaining or producing income from the business;^[5] 
• not be a personal expense;^[6] and
• must be reasonable in the circumstances.^[7]
• be consistent with ordinary principles of commercial trading or well accepted principles of business practice.^[8]

There are three categories of expenses:

• Current: Costs for things typically used up within a year, and for services. Examples include office supplies, a cell phone plan, travel, advertising, accounting services, operating an automobile (gas, insurance, maintenance), and work space in a home (rent, ppty tax, utilities). Typically, 100% of the business portion of an expense can be deducted for the year in which the expense is incurred.
• Inventory: Goods and materials bought for resale or to be incorporated into something sold or supplied to a customer. For example, this could include items bought from wholesalers and resold on eBay, plants bought by a landscaper and planted in a client’s yard, or fabric used to make clothes sold on Etsy.

Generally, you deduct the cost of inventory when it is sold or used, rather than when you buy it. The deduction for the year is generally calculated as:

Opening inventory + purchases during the year − closing inventory = cost of goods sold

For example, if you start the year with $10,000 of inventory, buy another $20,000 of goods and materials during the year, and have $5,000 of inventory left at the end of the year, your cost of goods sold is $25,000 ($10,000 + $20,000 − $5,000).

• Capital: Things that provide a lasting benefit, usually for longer than a year, such as cars, tools, computer equipment and buildings. Instead of deducting the full cost as an expense in the year of purchase, you generally deduct part of the cost over a number of years.

For example, suppose a car is purchased for $30,000 and used only for business. In the first year you might deduct $13,500 and then further amounts in subsequent years.

Unlike for current expenses, capital expenses are grouped into “classes,” and each class has rules that determine the maximum amount that can be deducted each year. Generally, the deduction is calculated collectively for all the items in the class rather than for each individual item. The annual deduction for a class is called capital cost allowance (CCA).

• Things that endure longer than a year, such as cars, tools, computer equipment, and buildings. Instead of a one-time expense deduction, the expense is divided and deducted over multiple years.  However, unlike for current expenses, capital expenses are grouped into ‘classes’ and deductions are calculated for the whole of the class rather than for individual items. Each year’s deduction for a class is called a capital cost allowance.  

CRA Resources:

The CRA has a number of resources for calculating expenses and capital cost allowance. These resources reflect the Income Tax Act, regulations, court rulings, and the CRA’s own policies and interpretations. They include:

• Guide T4002 - Self-employed Business, Professional, Commission, Farming, and Fishing Income
• Business expenses - Canada.ca - CRA webpage
• Current or Capital Expenses - CRA webpage
• Capital Cost Allowance - CRA webpage
• How to complete the capital cost allowance (CCA) charts - CRA webpage
• Income Tax Folio S4-F2-C1, Deductibility of Fines and Penalties
• Income Tax Folio S4-F2-C2, Business Use of Home Expenses
• Income Tax Folio S3-F4-C1, General Discussion of Capital Cost Allowance
• Income Tax Folio S4-F14-C1, Artists and Writers
• IT-518R - Food, Beverages and Entertainment Expenses (archived)
• IT-473R - Inventory Valuation (archived)
• IT-364 - Commencement of Business Operations (archived)
• IT-417 - Prepaid Expenses and Deferred Charges (archived)

Do you include HST when reporting expenses?

If you are not registered for HST under the Excise Tax Act, then the expenses you claim on the T2125 should include HST. If you are HST-registered, then don’t inlcude HST.

However if you use the Quick Method for your HST return, then capital expenses should include HST but capital expenses should not inlcude HST. This is explained in more detail in a separate document: HST registration, collection and reporting.

Cash v. Accrual Accounting:

The Income Tax Act does not explicitly require self-employed individuals to use either the cash or accrual method. However the CRA generally requires the accrual method to be used. According to Guide T4002:

 "Farmers, fishers and self-employed commission agents can use the cash method or the accrual method to report income. All other self-employment income must be reported using the accrual method."

Under the accrual method you report income in the year you earn it, no matter when you receive it; and you deduct an expense in the year it was incurred, even if paid later.

For example if you buy office supplies in 2025 on credit and pay the invoice in 2026, the expense is deducted in 2025.

Record Keeping:

The Income Tax Act requires self-employed persons to keep records at the person’s place of business “in such form and containing such information as will enable the taxes payable under this Act… to be determined.”^[9] 

Records must be kept for 6 years from the end of the last taxation year to which the records relate.^[10] However if a return is filed late, the 6-years does not begin to run until a return is filed.^[11]

If you have many expenses, it’s a good idea to open a second personal bank account and get a second credit card, and to use these for business expenses.

It’s good practice to use a spreadsheet to record and keep track of revenue and expenses. You could also use special accounting software such as QuickBooks, but for most small business such software is unnecessary.

Specific rules for expense records if you are HST-registered, to support input tax credits:

If you are HST-registered you will do an annual HST return. Upon filing a return you may recover the HST portion of your expenses. When doing a return it is usually necessary to report the HST you paid on your expenses, which are referred to as “input tax credits”.  

The Excise Tax Act states that you cannot claim an input tax credit unless you have supporting documents with prescribed information.^[12]  This requirement is mandatory and can be strickly enforced.^[13] However, the CRA has the discretion to waive the

strict requirements.^[14] The supporting documentation can be something other than an invoice and doesn’t have to be contained in a single document.^[15] A regulation under the Act sets out the required information:^[16]

No matter what the expense amount, the supporting documents must show:

• the supplier’s business name
• invoice date, or if there is no invoice the date when the HST was paid/payable
• total amount paid/payable

If the expense amount is over $100 the documents must also show:

• the amount of HST charged or a statement that the amount includes HST
• the supplier’s HST registration number

If the expense amount is over $500 then further prescribed information is required, including:

• your name (or your business name)
• a description of each good or service sufficient to identify it

Motor Vehicle Expenses - gas or electricity, insurance, maintenance:

There are no special rules in the Income Tax Act for motor vehicle current expenses.

If you use your car for both personal and business purposes, the CRA wants you to have a logbook, to record the odometer reading at the start and end of year, and to record the kilometers travelled for each business-related trip along with some details such as date, destination, and purpose. You can then calculate the percentage business use and multiply that by the total expenses.

The CRA could send a review letter requesting the logbook, particularly if you claim a high percentage of personal use in relation to the type of business you operate. Here is an excerpt from an actual review letter:^[17]

A log book is not a prescribed requirement under the Income Tax Act, however it is an obvious type of record that woud satisfy the general ITA requirement to keep records. If you didn’t keep a log book and your expenses are reviewed by the CRA, the CRA may make some assumptions and recalculate your allowed expenses or possibly deny them. To challenge the CRA’s assessment without a log book you would need some alternative reasonable evidence to support your calculations.

An example dispute is described in the court case Lisa Dale v. HMQ (2010 Tax Court). A real estate agent claimed that 95% of her travel was for business, but she hadn’t keep a log book as she claimed it was too onerous given the nature of her business. The CRA assessed 55%. The agent presented alternate indirect evidence in court to support her calculation. The court was not fully persuaded by either side’s position, and issued a decision allowing 75%.^[18]

Of course if a car is only being used for business purposes then a log book would not be necessary.

Work space in the home - when can expenses be deducted:

If you use a part of your home for business purposes, you can claim expenses relating to that part of the home (a “work space”) only if one of two tests are satisfied for that space:^[19]

• it is your principal place of business; or
• it is used exclusively for your business and is used on a regular and continuous basis for meeting clients, customers or patients.

The Income Tax Act doesn’t actually use the word “home”, but instead uses “self-contained domestic establishment in which the individual resides”. A self-contained domestic establishment is defined in the Act to mean a “a dwelling-house, apartment or other similar place of residence in which place a person as a general rule sleeps and eats”.^[20] 

If you live in rented premises with your landlord, the premises could qualify as a self-contained domestic establishment.^[21]  However a room (or rooms) in a hotel, dormitory, boarding house or bunkhouse would not ordinarily be considered a self-contained domestic establishment.^[22] 

Work space in the home - calculation of expense:

The Income Tax Act doesn’t prescribe a method or formula for calculating the expense, and in theory any reasonable calculation, supported by evidence, is acceptable. However the CRA provides methods it deems reasonable.^[23]

Typical expenses include rent or property tax, mortgage interest, utilities, and home insurance. If you own the home you could claim capital cost allowance, but that is rarely done obecause it affects the principal residence exemption and could result in capital gains tax when the home is sold.

• If the work space is used exclusively for business, then the calculation is simple: multiply expenses by the percentage work space. For example if a home has a dedicated room for business with area that is 10% of the home’s total floor area, then the deductible expense is 10% of total home expenses. If, for example, the individual works most of the time at customer locations and doesn’t use his home space much, the calculation is still the same as long as the work space is used exclusively for business.^[24]
• If the work space is used partly for both business and personal living, you do the above calculation, but then multiply by the percentage of business hours. For example, lets say the work space is 10% as in the above example, but its used 8 hours a day Monday to Friday all year, and during the remaining time it is used, or could be used, for personal living. The deductible expense is:

[total expenses] x 10% x (40 hours per week / 168 hours per week).

Calculation disputes have arisen between individuals and the CRA.^[25]

Work Space in the home - expenses can’t be used to create or increase a business loss:

The home office expenses you want to deduct cannot exceed your business income.^[26] In other words, you cannot create or increase a business loss with work space expenses. However, if because of this rule you can’t deduct all your work space expenses in the current year, then you can carry them forward to a future year until the expenses can be deducted. They must be used in the earliest subsequent tax year in which it is possible to do so.

Is the work space a principal place of busines if you conduct most of you business outside the home?

The term ‘principal place of business’ is not defined in the Income Tax Act. Some individuals carry on most of their business activity outside the house but use space in their home to do administrative work such as communicating with customers, billings, bookkeeping, ordering supplies, scheduling, maintaining a website, or other such things. This could be the case for construction and landscape contractors, personal trainers, farmers, and many other occupations.

In such cases your work space at home can qualify as your principal place of business and you can deduct expenses.^[27]

Capital Cost Allowance:

On a tax return, depreciation expense (called capital cost allowance, or CCA) is generally calculated for groups of items rather than individual items. Each group is a “class” and has its own depreciation rate. The T2125 has numerous columns for calculating CCA, but the two main ones are:

1. UCC at the start of year:

The undepreciated capital cost (UCC) at the start of the year is essentially the portion of the capital cost of property in the class that has not yet been deducted for tax purposes. For example, if you bought various Class 8 items that cost a total of $10,000 and over previous years claimed $6,000 of CCA, your opening UCC would generally be $4,000.

The UCC at the start of the year is the UCC at the end of the previous tax year. The amount can therefore generally be obtained from the previous year’s T2125, in the last column of the CCA table.

2. Cost of additions in the year:

The cost of additions to the year is the total cost of all new items of the class acquired in the year.

With these two amounts, the CCA for the year, and the UCC at the end of year, can be calculated.  For example:

• UCC at start of year for Class 8: $1000
• Cost of new Class 8 items in the year: $2000
• Class 8 CCA rate: 20%

CCA for the year: $1000 + ($2,000 x ½) x 20% = $400

UCC at end of year = (1,000 + $2,000) - $400 = $2,600

Note that The $2,000 of additions is subject to the half-year rule. Under this rule, only half of the net additions is generally included in the amount on which CCA is calculated in the year the property is acquired. The rule approximates the fact that property is acquired at different times during the year by effectively allowing half a year’s CCA on new additions.

When tax preparation software gives you a choice about whether the half-year rule applies, it should generally be applied unless a special rule provides otherwise.

CCA rates for common items:

Note that if a rate is 100%, the item is effectively treated the same as a current expense, i.e. all of the cost can be deducted in the year of purchase.

Altered rates for 2026 purchases (aka ‘additions’):

Special rules apply to many capital items purchased in 2026:

• Class 50: Although the usual CCA rate is 55%, computer equipment purchased in 2026 can generally be deducted at 100% in the first year.
• Class 8: Although the usual CCA rate is 20%, qualifying purchases in 2026 effectively receive a 30% first-year rate, and the half-year rule does not apply.
• Class 10: Although the usual CCA rate is 30%, qualifying purchases in 2026 effectively receive a 45% first-year rate, and the half-year rule does not apply.
• Class 10.1: For passenger vehicles acquired in 2026, the capital cost is capped at $39,000 plus applicable sales tax. Although the usual CCA rate is 30%, qualifying purchases in 2026 effectively receive a 45% first-year rate, and the half-year rule does not apply.

What is a “passenger vehicle” versus a “motor vehicle”?

Most vehicles are passenger vehicles.  CRA Guide T4002 has the following table:

From a tax perspective, what is the advantage of purchasing a motor vehicle over a “passenger vehicle”?

The CCA capital-cost limit that applies to a passenger vehicle does not apply to a “motor vehicle.” For example, if a motor vehicle is purchased for $60,000 in 2026 and used entirely for business, the first-year CCA would be:  $60,000 × 45% = $27,000

If the same vehicle were instead classified as a passenger vehicle, its capital cost for CCA purposes would be limited to $39,000 (plus applicable sales tax). Its first-year CCA would therefore be:  $39,000 × 45% = $17,550 (before taking sales tax into account).

Generally speaking, it is advantageous to depreciate property faster because the tax saving occurs sooner.

Passenger Vehicle Lease:

A lease expense is a current expense, but a special rule applies In particular, there is a prescribed cap determined by a formula. For new leases entered into on or after January 1, 2025 the prescribed monthly limit is about $1,100 per month plus tax.^[29]  The cap usually increases each year, but not always.

Meals and Entertainment:

You can generally claim 50% of reasonable food, beverage and entertainment expenses incurred for business purposes. Examples include meals while travelling for business and meals or entertainment with clients.

You can claim 100% of food and entertainment expenses for an office party or similar event to which all employees at a particular location are invited, up to six such events per year. You can also claim 100% of expenses for a fund-raising event mainly for the benefit of a registered charity.

References:

• Guide T4002 - Self-employed Business, Professional, Commission, Farming, and Fishing Income
• Business expenses - Canada.ca - CRA webpage
• Current or Capital Expenses - CRA webpage
• Capital Cost Allowance - CRA webpage
• How to complete the capital cost allowance (CCA) charts - CRA webpage
• Income Tax Folio S4-F2-C1, Deductibility of Fines and Penalties
• Income Tax Folio S4-F2-C2, Business Use of Home Expenses
• Income Tax Folio S3-F4-C1, General Discussion of Capital Cost Allowance
• IT-518R - Food, Beverages and Entertainment Expenses (archived)
• IT-473R - Inventory Valuation (archived)
• IT-364 - Commencement of Business Operations (archived)
• IT-417 - Prepaid Expenses and Deferred Charges (archived)
• RC4022 General Information for GST/HST Registrants
• Excise Tax Act (HST registration, collection, etc)
• Amendments to CRA re: reporting rules for digital platform operators.
• Liaison Office website
• Driversnote website - tax guides for Uber Eats and others
• Income Tax Act, s.125(6) - Personal Service Business
• Personal Service Business - CRA webpage