Volume 4, Number 1
The information in Tax Perspectives is prepared for general interest only. Every effort has been made to ensure that the contents are accurate. However, professional advice should always be obtained before acting on the information herein.
Rules for Capital Losses
Stock markets performed well in 2003. Many clients may have realized capital gains. Now the market has softened. You may want to trigger unrealized capital losses to recover capital gains taxes paid in 2003. This article provides a review of the rules for doing so.
A capital loss occurs on a sale of capital property when the cost exceeds the proceeds and selling expenses. Allowable capital losses (being one-half of the capital losses) can be offset against taxable capital gains in the year. Subject to certain exceptions, an allowable capital loss cannot be applied against other income. If the allowable capital losses exceed the taxable capital gains in the year, the difference becomes a net capital loss, which may be carried back three years and forward indefinitely to be deducted against taxable capital gains.
Carry Back to Prior Year
Most people with capital losses in the current year will first carry them back against previous capital gains. Where capital gains were realized in any of the three previous years, this strategy would normally be used. However, there will be at least two exceptions.
If an individual were in a low tax bracket in the previous year, or had little or no tax to pay, then it may be better to carry the loss forward.
For Canadian-controlled private corporations, where dividends have been paid triggering a "dividend refund", a net capital loss carryback may undo the dividend refund. This will negate most of the benefit of the carryback at the federal level. If so, consider a carryback claim for provincial purposes only, and carry the loss forward for federal purposes.
For persons with U.S. investments, the rise in the Canadian dollar will have caused a decline in the value of such investments as measured in Canadian currency. This can result in capital losses on realization. The losses may be very sizeable and are often overlooked on such assets as U.S. bonds, T-bills, and bank accounts. This potential source of capital losses should be carefully examined.
Superficial Loss Rules
Persons with capital gains will be concerned about realizing losses to offset the gains, but care must be taken in how the loss is realized.
If you sell property to trigger a capital loss, and you or an "affiliated person" buy identical property within 30 days before or after the sale, the capital loss will be a "superficial loss" and denied for tax purposes.
The denied loss is added to the adjusted cost base of the property. An affiliated person includes yourself, your spouse, any company that you or your spouse control, any partnership in which you are a majority interest partner, and due to recent amendments, certain family trusts, but it does not include children, siblings or parents. Of course, if the property is sold outright in the market and not replaced, these rules are not a concern.
Special Use of the Superficial Loss Rules
The superficial loss rules can be used to one's advantage. Suppose one spouse, A, has realized capital gains and the other spouse, B, holds investments with unrealized capital losses.
The loss investments are transferred by B to A at fair market value. As transfers of property to a spouse are deemed to take place at cost, an election must be filed with B's return for the transfer to take place at fair market value. The superficial loss rules will deny the loss realized on the transfer, provided that A still owns the property 31 days after the transfer. The denied loss will be added to A's cost of the property. The investments can then be sold by A on the open market to realize the loss, and the loss can be used to offset A's capital gains.
CRA does not like this technique and could try to apply GAAR. However, see the comments under In Brief concerning GAAR and Foreseeable Loopholes.
No Capital Loss Allowed on a Transfer to an RRSP
A contribution of investments to an RRSP cannot trigger a capital loss. The loss is denied, with no adjustment to the cost base. As a result, a transfer to your RRSP of a property with an accrued capital loss is generally not advisable. Instead, you might consider selling the loss property outside of the RRSP and using the cash proceeds to make a contribution to the RRSP.
Capital losses can be claimed by trusts in accordance with the normal rules for individuals. However, they cannot be allocated out of the trust to beneficiaries. We do, however, have some planning options to overcome this.
Allowable Business Investment Losses ("ABILs")
ABILs are a special type of capital loss that may be deducted from all sources of income for the year. ABILs arise when there is a capital loss on shares or debt of a corporation that, at any time in the 12 months preceding the loss, was a "small business corporation."
A "small business corporation" is a Canadian-controlled private corporation, where all or substantially all of the corporation's assets (90% by value) are used principally in an active business carried on primarily in Canada.
The loss must occur on a disposition to an arm's length person, unless the loss results from a "deemed disposition". A deemed disposition of a debt for nil proceeds will occur if it has become a bad debt during the year. A deemed disposition of a share for nil proceeds will occur at the end of a taxation year if the corporation is bankrupt, is being wound up or, subject to certain conditions, is insolvent and no longer carries on business. The taxpayer must make an election in his or her tax return for the year in order to have the deemed disposition apply. Non-arm's length inter-corporate debt cannot be used for ABIL treatment.
If an ABIL is not utilized in the year in which it arises, it can be carried back three years or forward seven years as a non-capital loss to offset all sources of income in those years. If the ABIL is not deducted at the end of the seven-year carryforward period, it becomes a net capital loss, which can be carried forward indefinitely to offset taxable capital gains in future years.
The amount of the ABIL that can be deducted against other income must be reduced by any capital gains exemption claimed in prior years. The amount of this reduction becomes a capital loss. In addition, if an ABIL is deducted against other income, an equal amount of taxable capital gains must be realized in later years before the capital gains exemption can be used again. These nuances can catch people unaware.
Capital Losses on Death
Any net capital losses carried forward at the time of death can be applied against all other income for the year of death and for the immediately preceding year, except to the extent the capital gains exemption has been claimed.
Personal Use Property
No capital losses are available on personal-use property, except for "listed personal property" losses, which can be used only against listed personal property gains. Listed personal property is generally property such as art, jewellery, rare books, stamps and coins used primarily for personal enjoyment or investment.
With proper planning before the end of the year, you may be able to minimize your tax on current year capital gains or recover taxes paid in a previous year. The record keeping for foreign currency accounting should not be underestimated, and realizing losses on currency conversion is not always easy. Early Fall is an excellent time for individuals to see where they stand on capital gains and losses, and to plan accordingly.