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.