Wednesday, July 15, 2015

Canadian Tax Primer 6: Intentional Capital Gains

In the Canadian Tax Primer 5 article, we pointed out that a lower tax rate applies to a capital gain as compared to ordinary income.  But what is a capital gain?

It is sometimes difficult to distinguish between a capital gain and ordinary income.  Much of the distinction has to do with the purpose behind the acquisition of the asset.  Characterization depends on specific facts, as illustrated by the following simplified examples.

Assume that you find that perfect piece of real estate and buy it for $100,000.  You plan to build your dream cottage on it, but not right away.  You are just starting a business and want the business to be established before you take on the cost of building the cottage.  As it turns out, the business takes more and more of your time and you realize that you do not have the time to make the trek to a far-off cottage.  After 15 years, you decide to sell the property for $500,000 and you use the cash to install a much more accessible swimming pool in the backyard of your home.  In this case, the $400,000 increase in value should be taxed as a capital gain.

Assume that you purchase the same piece of real estate because you anticipate that you will be able sell the property for a tidy profit once the area becomes a cottage haven.  You have to wait for 15 years, but events turn out as you anticipate.  The cottage building frenzy finally starts and you sell the real estate for $500,000.  In this case, the $400,000 increase in value should be taxed as ordinary income.

The only difference between these two examples is your intention when you buy the real estate.  In the first example, you buy the real estate for the purpose of building a cottage on it but you never actually build the cottage.  In the second example, you buy the real estate for the purpose of reselling it.

The same question arises with publicly-traded investments.  If you buy a share of Bell Canada and hold those shares for a year or so, sale proceeds will usually be treated as a capital gain – even though making a profit on resale gain is usually one of the purposes in buying shares.  This has to do with the nature of investments, as everyone hopes that the investments will grow in value over time.  But not all sales of Bell Canada shares will give rise to a capital gain.  If you are a day trader who buys and sells shares on a daily basis, your profit will likely be treated as ordinary business income.  Unlike the ordinary investor, a day trader is in the business of buying and selling shares.

While you may know what your intention was in purchasing an asset, it may be difficult to prove that intention to the Canada Revenue Agency (the “CRA”) if that should become necessary.  The CRA will determine your intention on the basis of external manifestations of that intention, the nature of the property involved and the amount of time you held the property.  No one factor will be determinative – characterization will depend on the combined impression created by all the relevant factors.

If the CRA reassesses a capital gain and treats the gain as ordinary income, the onus of proof will be on you to establish otherwise.  Keep any evidence that may be relevant to establishing your intention.  For instance, in the cottage example discussed earlier, keep any building sketches that you may have made for the cottage you never ended up building.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.