BUSINESS EXPENSES and CAPITAL COST ALLOWANCE
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] The net income can be negative, which is a loss.
Gross income, deductions, and net income are calculated using a T2125 form. Tax prep software will generate a T2125 form based on information provided.
Much of the information entered into a T2125 is submitted to the CRA upon efiling.[4]
The Income Tax Act doesn’t have a closed list of what deductions are allowed. But it does set out general principles, along with some specific rules for some types of expenses.
Core general principles: To qualify as a deductible business expense it must:
There are three categories of expenses:
The general idea behind the method of deduction is that you should only be able to deduct the cost of inventory to the extent the inventory is sold or used in a year. The deduction for a year is 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, the cost of goods sold is $25,000 ($10,000 + $20,000 − $5,000). The $25,000 amount represents the net inventory sold in the year.
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 with current expenses, capital expenses are grouped into “classes,” and each class has rules that determine the maximum amount that can be deducted each year. 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).
Should HST be included when reporting expenses?
If a person is not registered for HST under the Excise Tax Act, then the expenses claimed on the T2125 should include HST.
If the person is HST-registered and the regular method is used then HST is not included for any expense. If the Quick Method is used then current 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 income is reported in the year earned no matter when received; and expenses are deducted in the year 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] A record is defined to include an “account, an agreement, a book, a chart or table, a diagram, a form, an image, an invoice, a letter, a map, memorandum, a plan, a return, a statement, a telegram, a voucher, and any other thing containing information, whether in writing or any other form.”[10]
Despite this requirement, if records are lacking an expense might still be successfully claimed if supported by a credible verbal statement.[11]
Records must be kept for 6 years from the end of the last taxation year to which the records relate.[12] However if a return is filed late, the 6-years does not begin to run until a return is filed.[13]
Second bank account, and spreadsheet:
If a person expects to have many expenses, it can be a good idea to open a second personal bank account and get a second credit card, and to use these for business transactions. This makes it easier to keep track of expenses, and may assist if the CRA reviews or audits expenses. Technically, some bank account agreements governing personal accounts might prohibit use of an account for business purposes, but in practice banks usually tolerate it.
It’s good practice to use a spreadsheet to record and keep track of revenue and expenses. A client could use special accounting software such as QuickBooks, but for most small businesses such software is probably unnecessary.
Specific rules for expense records if the client is HST-registered, to support input tax credits:
Upon filing an HST return a person may recover the HST portion of their expenses. When using the regular method it is necessary to report the HST paid on expenses. The HST paid on an expense is referred to as an “input tax credit”.
The Excise Tax Act states that a personn cannot claim an input tax credit unless they have supporting documents with prescribed information.[14] This requirement is mandatory and can be strictly enforced.[15] However, the CRA has the discretion to waive the strict requirements.[16] The supporting documentation can be something other than an invoice and doesn’t have to be contained in a single document.[17] A regulation under the Act sets out the prescribed information:[18]
No matter what the expense amount, the supporting documents must show:
If the expense amount is over $100 the documents must also show:
If the expense amount is over $500 then further prescribed information is required, including:
Motor Vehicle Expenses - gas or electricity, insurance, maintenance:
There are no special rules in the Income Tax Act for calculting motor vehicle current expenses.
If a person uses their car for both personal and business purposes, the CRA wants them 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 details such as date, destination, and purpose. At tax time the logbook allows one to calculate the percentage business use.
The CRA could send a review letter requesting the logbook, particularly ifa high percentage of personal use is claimed in relation to the type of business operated. Here is an excerpt from an actual review letter:[19]
Keeping 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 requirement to have records. If a log book was not kept and expenses are reviewed by the CRA, the CRA may make some assumptions and recalculate allowed expenses or possibly deny them. To challenge the CRA’s assessment without a log book, some alternative reasonable evidence to support calculations would be needed.
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 kept 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%.[20]
Of course if a car is only being used for business purposes then keeping a log book would not make sense.
Work space in the home - when can expenses be deducted:
If part of a home is used for business purposes, expenses can be claimed that relate to that part (the “work space”) only if one of two tests are satisfied for that space:[21]
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”.[22]
If a person lives in rented premises with their landlord, the premises can still qualify as a self-contained domestic establishment.[23] However a room in a hotel, dormitory, boarding house or bunkhouse would not ordinarily be considered a self-contained domestic establishment.[24]
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 advises of methods it deems reasonable.[25]
Typical expenses include rent or property tax, mortgage interest, utilities, and home insurance. If a home is owned then a capital cost allowance could be claimed, but that is rarely done because it affects the principal residence exemption and could result in capital gains tax when the home is sold.
[expenses] x 10% x (40 hours per week/168 hours per week) x (35 weeks/52 weeks).
Calculation disputes have often arisen between individuals and the CRA.[27]
Work Space in the home - expenses can’t be used to create or increase a business loss:
Home office expenses cannot exceed business income.[28] In other words, a person cannot create or increase a business loss with work space expenses. However, if because of this rule the total work space expenses cannot be deducted in the current year, the balance can be carried forward to a future year, but they must be used as a deduction in the earliest subsequent tax year in which it is possible to do so.
Is the work space a principal place of busines if activities are mostly conducted 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.[29]
Capital Cost Allowance:
On a tax return, a 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 the CCA of classes, but the two main columns are:
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 various Class 8 items were bought in past years for a total cost of $10,000 and over those years $6,000 of CCA were claimed, the UCC at the end of the year would be $4,000 and that figure is the opening UCC of the next year.
The previous year’s UCCs for each class can be obtained from the previous year’s T2125, in the last column of the CCA table.
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:
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, by default, subject to the half-year rule. Under this rule, only half of the net additions is included in the amount on which CCA is calculated in the year the property is acquired. The rule reflects the fact that property is acquired at different times during the year. Rather than complicating the calculations, the CRA allows you to claim half the depreciation for new additions.
When tax preparation software gives 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:
Item | Class | Usual Rate | Temporary Effective Rate |
Computer equipment, including cell phones[30] and tablets. | 50 | 55% | 100% |
Computer software, Tools less than $500. | 12 | 100% | |
Office equipment, other equipment, tools more than $500, machines, furniture, musical instruments, photography equipment, microphone | 8 | 20% | 30% |
Passenger vehicle costing the threshold amount or less before tax.[31] | 10 | 30% | 45% |
Passenger vehicle costing more than the threshold amount before tax. | 10.1 | 30% | 45% |
Zero-emission passenger vehicle costing the threshold amount or less before tax.[32] | 54 | 30% | 100% |
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. If a person isn’t HST registered, or is HST registered and using the regular method, it can make sense for simplicity to enter computer equipment, computer software, and tools under $500, as current expenses.
Special CCA rules for 2026 purchases (aka ‘additions’):
Special rules apply to certain capital items purchased in 2026:
Capital Cost Allowance when item is only partly used for business:
..[to do]
Vehicle - Changing from Personal to Business Use:
..[to do]
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). The first-year CCA would therefore be: $39,000 × 45% = $17,550.
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 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.[33] The cap usually increases each year, but not always.
Conventions:
Expenses for attending up to two conventions per year can be claimed. The attendance must be in connection with the person’s business, and held by a business or professional organization at a location that is reasonably consistent with the terrirorial scope of that organization.[34]
Meals and Entertainment:
A person can claim generally claim 50% of reasonable food, beverage and entertainment expenses incurred for business purposes.[35] Examples include the cost of meals while travelling for business and meals or entertainment with clients.
A person can claim 100% of food and entertainment expenses for an office party or similar event to which generally all employees at a particular location are invited, up to six such events per year.[36] One can also claim 100% of food expenses for a fund-raising event held mainly for the benefit of a registered charity.[37]
References:
[2] Symes v Canada (1993 SCC) “In other words, the "profit" concept in s. 9(1) is inherently a net concept which presupposes business expense deductions. It is now generally accepted that it is s. 9(1) which authorizes the deduction of business expenses.”
[3] Professional, commission, farming and fishing income are also forms of business income, but would not typically apply to low-income earners.
[4] See CRA’s Guide RC4018, Electronic Filers Manual. It refers to “selected financial data (SFD) records” which are created by tax prep software. SFD type 02 is identified as Form T2125 (business). Appendix G2 lists line numbers on forms to be included in SFD records, including SFD02. The appendix includes essentially all the lines on a T2125 that are numbered, including 8000, 8299, all of the line numbers in Parts 3C, 3D, 4 and 5. Part 7 and Area A are not included, but CCA Equipment additions are included. The Charts at the end of T2125 are not included. Chapter 2 of the Manual lists potential efile error messages relating to SFD submissions, in particular error codes starting with ‘Y’. Some of the error codes address information in the T2125 besides line numbers. For example Y80007 (fiscal period), Y80002 (industry code), Y80034 (method of accounting). The possibility of SFD submission errors for SFDs show that SFD data is transmitted to the CRA, since the errors are only generated upon submission. In addition, in response to a FOI request made in October 2026, the government replied: “When you file your personal tax return electronically via NETFILE or EFILE, every field that contains a line number or code on Form T2125 is transmitted to the Canada Revenue Agency (CRA). Your tax software converts these specific lines into a digital data string (XML format) for the CRA's systems. The specific fields transmitted include:..” The message goes on to list the vast majority of fields listed on T2125.
[5] ITA, s.18(1)(a).
[6] ITA, s.18(1)(h). See also s.248(1) which doesn’t define “personal or living expenses”, but sets out some specific things that it includes.
[7] ITA, s.67. It was said in Morris v. R. (2006 Tax Court): “The concept of reasonableness, and its converse, unreasonableness, appear frequently both in income tax law and in other areas of the law. They are terms of some elasticity. They are easier to recognize than to define. If the court is directed by the law to determine what is "reasonable" it requires the application of judgement and common sense..”
[8] This principle is derived from case law. Cases often cited for the principle are: Symes v Canada (1993 SCC) and 65302 British Columbia Ltd. v The Queen (1999 SCC).
[11] Tax court decisions have established that oral evidence can suffice in court. The Supreme Court of Canada said in Hickman Motors Ltd. v. R. (1997): “...credible oral evidence from a taxpayer is sufficient notwithstanding the absence of records” See also Benjamin v. The Queen (2006 Tax Court): “Whatever may be the policy of the CRA to require documentation to support an expense, a payment or a deduction, it is not the policy of this court, unless the taxing statute specifically requires it (as for example, in the case of charitable donations). If a taxpayer in court can demonstrate through credible oral testimony that a payment was made or an expense incurred, the court must make a finding based on that evidence and give effect to it.” This is reflected in the CRA’s Audit Manual, s.10.5.0, Audit Evidence, which states: “Remember that oral audit evidence is, in fact, audit evidence. It is therefore incorrect to say, when the taxpayer has made a verbal statement, that there is no audit evidence, even when there are no supporting documents or other individuals able to corroborate the taxpayer's statements. The taxpayer's own testimony constitutes audit evidence that, if credible, can support what was said, and even serve as proof.”
[15] See Systematix Technology Consultants Inc. v. The Queen (FCA 2007)
[17] Some example analyses are found in McDavid v. HMQ (Tax Court 2014), Fiera Foods Company v. The King (Tax Court 2023), Boylu v The King (Tax Court 20525 - involving an Uber driver), Mediclean Incorporated v. The Queen (Tax Court 2022 - good summary of law starting at paragraph 48)
[18] Input Tax Credit Information (GST/HST) Regulations 91-45 For summary, see this CRA webpage.
[19] This image was acquired from a 2026 Reddit post.
[20] There are many tax court cases involving individuals who did not have a log book or they ‘reconstructed’ one. Some examples: Larkin v HMQ (2020 Tax Court - paragraph 26); Watts v. The Queen (2005 Tax Court - paragraphs 8 and 9); Platis v HMQ (2010 Tax Court - paragraph 17); Schumaker v. The Queen (2002 Tax Court - paragraphs 8 to 9); Jha v. The Queen (2002 Tax Court - paragraphs 14 to 17); Jensen v. HMQ (2007 Tax Court - paragraphs 25 and 26); Li v. The Queen (2009 Tax Court - paragraph 14); Morrissey v. HMQ (2011 Tax Court - paragraphs 8 to 13); Richter v. The Queen (2001 Tax Court - paragraph 22); Walker v. The Queen (2011 Tax Court).
[21] Income Tax Act, s.18(12)(a). This two-test rule was introduced in 1988.
[23] See tax interpretation letter 2010-0367501E5
[24] Folio S4-F2-C2, paragraph 2.6
[25] See primarily: Income Tax Folio S4-F2-C2 Business Use of Home Expenses and Guide T4002, Chapter 3, Line 9945, which includes an example.
[26] See severed letter tax interpretation 2000-0008905
[27] Some examples of court cases exhibiting a dispute over percentage calculations: Khoury v. The Queen (2006 Tax Court) involving an artist; Ryan v. The Queen (2006 Tax Court) involving a physical therapist; Cocos v. The Queen (2016 Tax Court) involving areas used for product and material storage; Walker v. The Queen (2011 Tax Court);
[28] Income Tax Act, s.18(12)(b)
[29] The leading case on this issue is Jenkins v. The Queen (Tax Court 2005) which involved spouses operating a fishing business. See also Tax Interpretation severed letter 2000-0008905.
[30] See tax interpretation letter 2009-0344551I7. This assume phone is bought outright, not leased.
[31] For 2025 the cap amount was $38,000 before tax. For 2026 it is $39,000. Ref: Regulation 7307 (but the Regulation may not be up-to-date with recent government announcements).
[32] For 2025 and 2026 the cap amount is $61,000. Ref: Regulation 7307.
[33] Income Tax Act, s.67.3. Regulation 7307(3). The actual limit is based on a 30 day month. The amount before tax is ($1,100 x 365)/30 for the year, which works out to $1,115 per month.
