Capital Gains and Losses

A capital gain arises when a capital property is disposed of and the proceeds of disposition exceed the adjusted cost base of the property plus the costs of disposition. A taxable capital gain is defined as 3/4 of the capital gain. A capital loss arises when capital property is disposed of and the proceeds of disposition are less than the combined amount of the adjusted cost base of the property and the disposition costs. An allowable capital loss is defined as 3/4 of the capital loss.

This sounds pretty simple, but the taxation of capital gains and losses is actually a very complex area. This chapter is intended to provide you with a source of information which will help you to deal with client questions on capital gains and also discuss relevant planning techniques.

To determine the amount of capital gain or loss it is necessary to obtain the answers to 4 questions:

• has capital property been disposed of?
• what were the proceeds of disposition?
• what was the cost (or adjusted cost base) of the property?
• what expenses, if any, were incurred in disposing of the property? (e.g. brokerage fees, real estate fees).

As a starting point, it must be stressed that only the disposition of capital property will result in a capital gain or loss. The Income Tax Act defines capital property as,

1. any depreciable property of the taxpayer, and
2. any property (other than depreciable property), any gain or loss from the disposition of which would, if the property were disposed of, be a capital gain or a capital loss, as the case may be.

That definition doesn't help much at face value, but capital gains arise on the disposal of a wide variety of specific assets (shares in a corporation, a partnership interest, bonds, debentures, mortgages, land, etc.). All of these can fit the description of capital property, except when they are held as inventory of a business.

Because capital gains are only 3/4 taxable whereas business income is fully taxable, it is important to determine whether a gain arose from the disposition of a capital asset or represents a gain from an adventure in the nature of trade (a business). Over the years the Courts have held that the disposal of a true investment (one that yields a return such as interest or rent, or that offers a reasonable expectation of a return in the foreseeable future) is a capital transaction. On the other hand, activities of a speculative nature have often been regarded as adventures in the nature of trade.

The following are some of the other principal tests applied by the Courts in capital gains cases:

1. Intention and Course of Conduct - was a profit deliberately sought? While not conclusive by themselves, quick turnover and active pursuit of a re-sale gain may both be indicative of a business venture rather than a capital transaction. Relevant consideration is the length of time the property was held. If it was a land transaction, how much effort was expended in developing the property and how actively was it advertised or offered for sale?
2. Number and Frequency of Transactions - while numerous and frequent transactions may be viewed as business income, the reverse is not necessarily true. An isolated transaction may still be considered to be of a business nature not on the basis of frequency but because of the nature of the transaction.
3. Relationship to Taxpayer's Business - a transaction that appears to be clearly of a capital nature may be held to be an adventure in the nature of trade solely because of a close connection with the taxpayer's regular business or profession. For example, stock market gains have sometimes been taxed as ordinary income in the hands of stock brokers.
4. Declared Objects of a Corporation - the objects written into a company's charter may be very broad, presumably to permit future expansion of activities. The Courts have at times taken the approach that the gain from a transaction, although unrelated to the company's usual business, came within the objects for which the corporation was formed, and was therefore taxable as business income.

It is seen that at times it is very difficult to determine whether a profit should be taxed as income or capital gain. Because capital gains are taxed more favorably than business income, it is likely that Revenue Canada will examine borderline situations more closely to see if business income treatment is applicable.

Proceeds/Costs of Disposition

In most cases, the proceeds of disposition of a property are relatively easy to determine as they reflect what the taxpayer received or is entitled to receive for the capital property. In some cases, transfers of property that do not give rise to proceeds will be deemed to be dispositions for tax purposes. This will include dispositions that are deemed to have occurred:

• immediately before the death of the taxpayer - refer to Chapter 6 for details
• when a gift is made during the taxpayer's lifetime - refer to Chapter 10
• when a taxpayer ceases to be a resident of Canada - refer to Chapter 4

Costs of disposition cannot be deducted from the capital gain once it has been calculated. Rather, costs such as redemption fees on mutual funds, brokerage fees or real estate fees on property must be accounted for separately prior to the calculation of the capital gain. To illustrate, if a taxpayer sold a property with an adjusted cost base of $20,000 for $25,000 and his costs of disposition were $2,000, his capital gain is $3,000 of which the taxable portion is 3/4 or $2,250. He could not calculate his capital gain as $5,000 of which 3/4 or $3,750 is the taxable portion and then deduct the $2,000 costs of disposition for a net taxable gain of $1,750.

Inadequate Consideration

When a taxpayer transfers property in a non-arm's length transaction for no proceeds or for proceeds less than fair market value, Sec. 69 provides that proceeds will be deemed to have been received equal to the fair market value of the property transferred. Thus, if father sells a capital property to son for $20,000 when, at the time, the fair market value of the property is $40,000, the deemed proceeds to father are $40,000 and his capital gain is calculated accordingly. A problem arises in that there is no adjustment to the cost base of the property in the son's hands - his adjusted cost base will be $20,000. This problem could have been avoided if the son had purchased one-half of the property for fair market value of $20,000 and father had gifted the remaining half of the property to his son. Where a transfer is made via gift to a non-arm's length person, there is still a deemed disposition by the transferor at fair market value, but the transferee is also deemed to acquire the property at its fair market value. The same result could be achieved if father transferred the property to the son for $20,000 of cash and a promissory note for the remaining $20,000. The note would subsequently be forgiven.

In the opposite situation, where capital property is transferred to a non-arm's length person for more than its fair market value, the transferee's cost base will be limited to fair market value whereas the transferor's proceeds (and subsequent capital gain) would be based on the amount of the transaction. To illustrate, if father sold a property with a fair market value of $40,000 to son for $50,000, father's gain would be based on the $50,000 proceeds while son's adjusted cost base would be limited to $40,000.

Where capital property is transferred to a spouse or where the property is in the form of an interest in a family farm, the disposition will not necessarily occur at fair market value. These areas will be covered in the section titled "Rollovers".

Cost of Capital Property

As one of the factors in measuring a capital gain or loss, it is necessary for the taxpayer to establish the cost (or adjusted cost base) of the property disposed of. For most taxpayers the original cost of the property will be known. However, another significant fact may affect the determination of cost for tax purposes - V-Day value.

V-Day Values

Recognizing that a capital asset held at the start of the capital gains system on January 1, 1972 might have had a fair market value at that time significantly different than its original cost, the government designated 2 Valuation Days:

1. December 22, 1971, for publicly traded common and preferred shares, rights, warrants and convertible bonds, and
2. December 31, 1971 for all other capital property.

The significance of the V-day value is that it can provide a substitute for cost in measuring a capital gain or loss when property owned at the end of 1971 is subsequently sold. Where an asset has a V-day value in excess of its original cost, the owner may realize a tax-free gain to the extent of the excess when he disposes of the property. On the other hand, if the V-Day price was significantly below cost, it would be unfair not to exempt any gain on the subsequent recovery of the market, at least up to the level of the original cost.

Accordingly, Revenue permits the concept of the "tax-free zone", essentially the spread in price between original cost and V-day value. Using the tax-free zone method, the deemed cost will be the median figure of cost, V-day value and proceeds of disposition. To illustrate, let's look at some examples.

In example A, the median figure (neither the greatest nor the least of the three) is $120. This amount is deemed to be the cost base and the capital gain on disposition is $10.

In example B, the median figure is $115 which represents the proceeds of disposition. Since the proceeds of disposition and the deemed cost are the same, no gain will result.

In example C, the median amount is $100. Even though the taxpayer suffered an overall loss of $25 (based on $120 original cost), only $5 occurred after V-day and that's all he can claim as a capital loss.

Election to use V-Day Values

An individual may, if he so elects, determine his adjusted cost base for each capital property owned at the end of 1971 by using its V-day value instead of the amount arrived at under the tax-free zone method. As a general rule, where most of the taxpayer's capital properties held at the end of 1971 had V-day values above their original costs, the use of the election was likely to be advantageous. The election must have been made with the individual's tax return for the first taxation year after 1971 in which he disposed of any of his pre-1972 holdings. Failure to make the election for the first year in which he disposed of any pre-1972 capital property meant that he was compelled to use the tax-free zone method for all pre-1972 holdings. If the election was properly made, the taxpayer could not later revert to the tax-free zone method.

Note that the election to use V-Day values only applies to individuals. Corporations must use the tax-free zone method.

Where an Investors client disposes of mutual fund units which were purchased prior to the end of 1971, we automatically calculate the capital gain or loss using the tax-free zone method. Investors refers to the tax-free zone method as the median method. If your client has made the election to use V-Day values (called the market method by Investors), we must be advised so that any capital gain or loss may be calculated accordingly. In order to advise Investors that a client has made the V-Day value election, he/she should advise Head Office.

Depreciable Property

Disposals of depreciable property held since before 1972 are also subject to a tax-free zone rule, but in a slightly different manner. Effectively, a tax-free zone occurs only where the fair market value of the property at the end of 1971 exceeded its capital cost. Thus, if the V-Day value of the depreciable property exceeds its original cost the excess will not be subject to tax on disposition.

To illustrate the tax-free zone for depreciable property, assume that a depreciable asset with a capital cost of $7,000 had a fair market value of $10,000 at the end of 1971 and it is subsequently sold for gross proceeds of $12,000, less disposal costs of $600. For capital gains purposes, the deemed proceeds will be a total of:

Thus, the capital gain is $1,400, based on deemed proceeds of $9,000 minus cost of $7,000 plus disposal costs of $600. Note that if the proceeds were less than the V-Day value of $10,000, no capital loss would have occurred. It is not possible to realize a capital loss on the disposition of depreciable property.

Identical Properties

In determining cost when a taxpayer disposes of part of a group of identical properties (i.e. shares of a particular public company), the average cost method must be used to determine the capital gain or loss. This is done by dividing the cost of all units owned by the number of units owned. This is fairly simple to do but it becomes a little more complicated when some of the identical properties were owned prior to 1972 and some were acquired after the end of 1971 (V-Day). Those properties will be treated as 2 separate groups of identical properties. The cost of the balance on hand at December 31, 1971 must be identified on a "first-in, first-out" basis. To illustrate how this works, here is an example of an individual who had the following transactions in the shares of X Ltd.

At the end of 1971, the individual has 800 shares. Of the 300 shares sold in 1970, the FIFO basis states that 200 were 1968 shares and the remaining 100 were 1969 shares. Thus, the individual has 400-1969 shares and 400-1971 shares on hand at December 31, 1971. The calculation of adjusted cost base of pre-1972 shares is:

The average cost of pre-1972 shares is $5.

hres acquired after 1971 go into a separate pool on which a separate average cost is calculated. Shares sold after 1971 are considered to have been drawn first from the pre-1972 pool and only when this pool is depleted are disposals made from the post-1971 pool. Every time shares are added to the post-1971 pool, a new average cost per share in the pool must be calculated.

Units in a particular mutual fund are a good example of identical properties. Every time a client purchases or redeems units of a fund, we do the calculations required to re-calculate the cost base of the fund units still held.

Brokerage Fees and Acquisition Fees on Stocks and Mutual Funds

We saw earlier that fees paid on the disposition of capital property are not fully deductible. Such fees are simply added to the cost base of the property, the total of which (cost base plus fees) is then deducted from the proceeds of disposition to determine the capital gain or loss. The same treatment applies to brokerage and acquisition fees paid when the stock or mutual fund is purchased in that the fee is included in the adjusted cost base of the property. To illustrate, suppose the NAV of a mutual fund unit is $5.00 and the client pays $5.40 public offering price. The 40¢/unit fee is not deductible in the year of purchase, but is included in his cost base of $5.40 per unit. If he later sells the unit of purchase was $1/unit.for $6.00, his capital gain is 60¢/unit of which 3/4 or 45¢ is the taxable capital gain even though the "real" gain from date

Superficial Losses

To prevent abuses, the Income Tax Act prohibits the deduction of a superficial loss, defined as a capital loss arising on a taxpayer's disposition of capital property where the same or identical property is acquired by the taxpayer, his spouse, or a corporation controlled directly or indirectly by the taxpayer, during a period commencing 30 days prior to or ending 30 days after the disposition of the property. Where the superficial loss rule applies, any loss will not be deductible, but will be added to the adjusted cost base of the substituted property.

Here's an illustration of how the rule works:

Mr. Client has 1,000 units of mutual fund X which has an adjusted cost base of $10,000 and a fair market value of $6,000. He sells the units on July 1. Mrs. Client, however, bought 500 units of fund X for $3,000 on June 10. Because Mrs. Client bought units of fund X between June 1 and July 30 (30 days prior to and 30 days after Mr. Client's disposition), Mr. Client's capital loss of $4,000 is not fully deductible but 50% will (because Mrs. Client purchased 50% of the number of fund units sold by her husband) be added to Mrs. Client's cost base of $3,000 for an adjusted cost base of $5,000. Note that with mutual funds, it is possible to avoid the superficial loss rule by purchasing units of a fund other than the one on which the capital loss is realized. If Mr. or Mrs. Client had purchased units of fund Y between June 1 and July 30, the rule would not apply even though fund X and fund Y may be distributed by the same company.

Capital losses on transfers of property to a self-administered RRSP, RRIF, DPSP or employee profit sharing plan are deemed to be zero for tax purposes whereas capital gains on such transfers are based on transfer at fair market value. For this reason, persons considering the transfer of capital property in a loss position to one of the above-noted plans should consider disposing of the property to realize the capital loss, repurchasing the same property (outside of the superficial loss time frame) and then transferring the property to the plan.

It is important to note that there is no rule similar to the superficial loss rule dealing with the realization of capital gains. If you choose to dispose of property at a gain and repurchase identical property within 30 days, your gain is realized for tax purposes.

Capital Gains Dividends

Despite the use of the word 'dividend', capital gains dividends are simply capital gains for tax purposes. The manager of a mutual fund is regularly trading capital properties such as stocks or bonds in order to get the best possible return for unitholders of the fund. In the trading of stocks and bonds, capital gains may be realized within the fund. Because the fund is likely taxed at a higher rate than its unitholders, the capital gains realized within the year (net of any capital losses) are allocated to the unitholders in the form of additional fund units or are distributed to unitholders in the form of cash. The amount of the allocation or distribution is a capital gains dividend to the unitholder, who reports the amount as a capital gain on his tax return.

This brings us to an important point with regard to Investors (and any other company) funds. Whenever a capital gains dividend is allocated or distributed, the fund price drops by exactly the amount of the capital gains dividend without exception. If capital gains dividend of $1 is allocated or distributed at a time when the NAV of the fund is $5, the NAV of the fund will drop to exactly $4 as a result. If you check the NAV of the fund at the next valuation date, it may be $4.20 or $3.50 or whatever, but this is due to the portfolio valuation on that date either being up by 20¢ or down by 50¢. The NAV will have been reduced by exactly $1 due to the distribution or allocation of the capital gains dividend. This being the case, when it is known that a capital gains dividend will be paid on a particular fund, should money be invested in that fund (or transferred from another fund) just prior to the allocation or distribution? The answer is an unequivocal no! Three-quarters of the amount of the capital gains dividend will be taxable even though no real gain has been realized. Using the numbers above, the client could wait until after the gain was allocated/distributed and buy units of the fund for $4 rather than paying $5, receiving a $1 capital gains dividend and paying tax on 3/4 or 75¢.

Capital gains dividends are a good sign for a mutual fund since they show that the manager is realizing profits on his trading within the fund. Remember, however, that the fund is valued on a regular basis and that the profits inherent in the funds assets are reflected in the NAV even before they are realized. After the manager has realized capital gains, the fund allocates/distributes the gain via the capital gains dividend. There is no economic benefit to the unitholder at the time the capital gains dividend is allocated/distributed since the gain is already reflected in the NAV of fund units prior to the distribution/allocation.

Stock Dividends

A stock dividend is a distribution of corporate profits to shareholders in the form of additional shares of the company rather than as cash as with an ordinary dividend. Thus, an individual holding 1,000 shares of X Ltd. who receives a 5% stock dividend will receive an additional 50 shares of X Ltd. rather than cash. From 1977 to 1985, the recipient of a stock dividend would not report the value of the stock as income in the year of receipt, but would be deemed to have acquired the shares at an adjusted cost base of zero. A subsequent disposition would result in capital gains treatment with the gain being calculated on the ACB of zero. Stock dividends declared and paid after May 23, 1985 are treated as taxable dividends in the year of receipt - subject, of course, to the gross-up and dividend tax credit. The actual amount of the dividend (prior to gross-up) becomes the adjusted cost base of the stock to the recipient.

Rollovers

As we have seen, capital property transferred to a non-arm's length person for inadequate consideration will be deemed to have been transferred by the vendor at its fair market value. There are exceptions to this rule where capital property may be transferred at less than fair market value. Let's take a brief look at each situation where a rollover is possible:

a) Transfer to a Spouse

- depreciable property transferred to a spouse is transferred at its undepreciated capital cost while other capital property is transferred at its adjusted cost base. The transfer is automatically assumed to be at UCC/ACB, but the transferor may elect (per Sec. 73(1)) that the transfer take place at fair market value. Note that the election to transfer capital property to a spouse at fair market value does not avoid the attribution rules (as discussed in Chapter 10), unless the transferee spouse pays full consideration for the property.

Where Investors funds are being transferred from one spouse to the other, we will effect the transfer at the adjusted cost base of the transferor. If the client wishes to have the transfer processed at fair market value, ensure that a note to that effect is included with the normal paperwork.

The same rollovers apply to capital property transferred to a spouse or spouse trust at death. This area is covered in detail in Chapter 6.

b)Transfers of Farm Property

- the rollover provisions apply to farm property, shares of a family farm corporation and interests in a family farm partnership which are transferred to the taxpayer's child, grandchild or great-grandchild who is resident in Canada. With transfers of farm property, there are two sets of rules, one for transfers of depreciable property and the other covering transfers of land. Where the required conditions are met, the taxpayer can make a gift of the property, or may sell it to the child for less than full value, without the transfer proceeds being deemed to be fair market value. In the case of depreciable property, the transferor may elect a transfer price which falls anywhere between undepreciated capital cost of the asset and fair market value. If the actual proceeds are below the lower of UCC or FMV, the lower amount of the two will be deemed to be the amount of proceeds received. Any capital gain and recaptured depreciation would be based on the elected transfer value although this is not common since the rollover is normally effected at undepreciated capital cost in order to transfer the property to a child without immediate tax consequences.

Essentially the same rules apply to transfers of farm land, except that the upper and lower limits of the deemed proceeds are the fair market value of the land and its adjusted cost base.

The transferee child is considered to have acquired the property for the same amount as that deemed to be proceeds to the transferor. Any capital gain or recapture resulting from a subsequent disposition of the property by the child is taxed to the child and not to the transferor provided the child is 19 years of age or over in the year of disposition. This treatment allows for tax planning opportunities as the parent/grandparent may wish to transfer property at a price which triggers sufficient capital gain to fully utilize his/her $500,000 capital gains exemption. Future growth in the property will then accrue to the child/grandchild so that on subsequent disposition of the property, his/her capital gains exemption will also be available.

The same upper and lower transfer limits of FMV and ACB apply to transfers of a share in a family farm corporation or an interest in a family farm partnership which is transferred to a child/grandchild. There is an important difference between the rollover of farm property to a child/grandchild and the rollover of capital property to a spouse as discussed above. When capital property is transferred to a spouse the elected transfer value must be either ACB (UCC if depreciable property) or fair market value. With the rollover of farm property to a child, the elected transfer value may be any amount between ACB/UCC and fair market value.

c) Transfers to a Corporation or Partnership

- Section 85 (corporations) and Section 97 (partnerships) of the Act allow for capital property to be transferred into a business entity with no immediate tax consequence to the transferor. As with farm property discussed above, the transferor may elect a transfer value of anywhere between the fair market value of the consideration received from the corporation or partnership in exchange for the property (lower limit) and the fair market value of the property transferred (upper limit). The transferor cannot elect a transfer value below the cost of the property transferred as the Act prohibits the deduction of a capital loss in such circumstances.

The transfer of capital property to a corporation or partnership is a fairly complex area and won't be dealt with further here. It is sufficient to be aware that such transfers are allowed with no immediate tax consequence to the transferor, but that if so desired, gains could be triggered if the elected transfer price exceeds the cost base of the property.

$500,000 Capital Gains Exemption

The $500,000 lifetime capital gains exemption is available only to individuals resident in Canada. It is not available to corporations and most trusts.

Prior to February 22, 1994, up to $100,000 of gains on any capital property were exempt. After that date, however, the exemption plus an additional $400,000 applies only to shares of a qualified small business corporation or qualified farm property. Both of these items will be covered in detail in a moment.

Prior to calculating the amount of the exemption to be utilized in a year, the taxpayer must first determine the net amount of capital gains for the year. This is done by adding the total amount of capital gains realized during the year and then deducting capital losses realized in the year, plus capital losses carried over from other years and allowable business investment losses. We'll discuss the carryover of capital losses and allowable business investment losses later in the chapter. Once the net capital gains are determined, the taxpayer has one more factor to consider prior to claiming his capital gains exemption - that is the extent of his cumulative net investment loss (CNIL) at the end of the year. Again, we'll look at the calculation of CNIL and its effect on the capital gains exemption later in the chapter.

Computation of the Deduction (i)

The deduction permitted in a year is the least of the 3 following amounts:

• the unused portion of the maximum deduction
• the annual gains limit for the year, or
• the cumulative gains limit at the end of the year

Let's look at the definition of each of the amounts:

1. The unused portion of the maximum deduction is the amount available in a year less the portion used up in previous years. The Income Tax Act refers only to the taxable capital gains deduction which is based on the taxable portion of the capital gain included in income. This amount is $375,000.
2. The annual gains limit for the year means:
   • the amount of net taxable capital gains on qualified property for the year (taxable capital gains less allowable capital losses)

Less:

• the amount of allowable capital losses from any property from other years which are claimed in the current year
• the amount of allowable business investment losses for the year - even if not deducted.

3) The cumulative gains limit is calculated as follows:

• the amount of net taxable capital gains from any property realized after 1984 to the end of the current year

Less:

• the amount of net capital losses for other years deducted after 1984
• the allowable business investment losses realized after 1984
• the allowable capital losses prior to May 23, 1985 deducted from other income in 1985 (max. $2,000)
• the cumulative net investment loss at the end of the year
• the capital gains deduction used in prior years

The 3 elements used in the calculation of the capital gains deduction may appear to be complex, but it is important to understand how the calculation works because, as we will see, there are times when a capital gain is realized but will not qualify for the deduction.

The object of the deduction is to exempt net capital gains realized after 1984, after having considered capital losses. The result may be termed "net economic gain". The use of the capital gains deduction is restricted to the net economic gains that have an effect on computing the taxable income of the individual.

An individual cannot use the cumulative capital gains deduction to offset net capital gains, and at the same time deduct allowable business investment losses and certain capital losses from other income. The use of the capital gains deduction is restricted to the net economic gains.

Here is an example of the use of the cumulative capital gains deduction and the concept of net economic gain:

Based on this information, here is the calculation of income and the capital gains deduction for each of the 2 years:

Computation of Deduction (ii)

In both 1996 and 1997, the deduction is equal to the net economic gains after 1984.

Here is a second example of the concept of net economic gain:

Based on this information, here is the calculation of income and the calculation of the capital gains deduction for each of the 2 years:

Computation of Deduction (iii)

In this example, even though the taxpayer realized net taxable capital gains of $33,750 in 1997, his capital gains deduction is zero. This is because he has cumulative (since 1984) allowable business losses of $33,750 as well, which results in a post-1984 net economic gain of zero.

Qualified Farm Property

- includes real property (land and buildings, but not machinery) used in a farming business in Canada, shares of a family farm corporation and interests in a family farm partnership. Also included, as of 1988, is eligible capital property (i.e. a milk quota). There are also requirements regarding the prior use of the property. Specifically, the property must have been used by the individual, his spouse, or child (including grandchild or great-grandchild) in the business of farming in the year of disposition or at least 5 years during which the property was owned by the individual, his spouse or child. This rule applies to real property owned prior to June 18, 1987. For real property acquired after June 17, 1987, it must also meet other requirements than those stipulated above. For at least 24 months preceding the disposition, the real property must have been owned by one of the persons noted above and furthermore, one of the following conditions must also be met:

• for at least 2 years, the gross revenue from the property for a fiscal period ending in the year for the person noted above must exceed his income from all other sources in the year. For example, if the owner of the property earned $24,000 per year from employment, his gross revenues from the farm in the appropriate years must exceed $24,000.
• through the 24-month period, the real property must have been used by a partnership or a family farm corporation in the course of carrying on the business of farming in Canada.

The purpose of the application of the gross income criteria and the requirement that the real property be used in a farming business is to allow the exemption only to individuals for which farming is their main activity.

Qualified Small Business Corporation Shares

- includes shares of a Canadian-controlled private corporation all or substantially all the assets of which were used principally in an active business carried on primarily in Canada. The shares must also satisfy 2 additional requirements in order to qualify for the exemption:

• throughout a period of 24 months immediately preceding the disposition, the shares must not have been owned by any other person or partnership other than a person or partnership related to the individual (i.e. his spouse)
• throughout the 2 year period noted above, more than 50% of the fair market value of the corporation's assets must have been used in an active business. At the time of disposition of the shares, more than 90% of the fair market value of the assets must have been used in an active business.

Occasionally, a corporation may temporarily lose its small business corporation status due to the fact that the fair market value of non-active assets exceed 10% of the total fair market value of all the assets of the corporation. This will not be a problem when there is a proposed sale of the shares as the corporation will be able to reduce the value of the non-active assets to less than 10% of all the assets prior to the disposition. However, on the death of a shareholder, a disposition is deemed to have occurred and the corporation may fail to meet the all or substantially all test at the time of death. The Act contemplates this potential problem by stating that shares disposed of as a consequence of death will qualify as small business corporation shares providing the stated criteria were met at any time in the preceding 12 months and only failed to meet those criteria at the time of death.

A further potential problem which could cause a corporation to lose its small business corporation status is where insurance policies are owned to fund buy-sell agreements and such policies have a fair market value which when added to the value of other non-active assets exceed 10% of the value of the company's assets. Again, the Act contemplates such a situation by stating that the value of a life insurance policy will be considered to be its cash surrender value if the proceeds from the policy were used by the corporation within 24 months from the death of the insured to redeem, acquire or cancel the decedent's shares of the corporation.

As noted above, the $500,000 exemption is only allowed on the shares of a small business corporation; the shares of a public corporation are not eligible. In order to prevent shareholders of a company that seeks to go public from losing out on the extra exemption, Sec. 48.1 enables the capital gains exemption to be triggered immediately prior to the company "going public". This is done via an election by the shareholders whereby shares are deemed disposed of for a value anywhere between ACB and fair market value. The election must be filed with the individual's tax return for the year in which the corporation goes public. Late filed elections (for up to 2 years) are permitted but a penalty tax will be applied by Revenue Canada. Note that shares in a holding company which held all or substantially all (i.e. 90%) of its assets in the form of qualified small business corporation shares, will be considered to be qualified small business corporation shares.

Capital Gains Reserves

In some cases, disposals of capital property may not result in immediate receipt of the full amount of the sale proceeds. Where a taxpayer disposes of capital property and doesn't receive the full sale proceeds (e.g. takes back a mortgage), he may deduct from any resulting capital gain a reserve in respect of the proceeds not due to him until after the end of the year. The maximum reserve to be claimed in a year is based on the following formula:

Let's look at an example where Mr. X sells a property in the current year for $200,000. He takes cash of $50,000 as a down payment and will receive the remaining $150,000 in 5 annual installments of $30,000 each. Note that any interest on the mortgage is taxable to Mr. X in the year of receipt and does not affect our reserve calculations. We'll assume that Mr. X's capital gain on the sale was $80,000.

In the year of sale the capital gains reserve is the lesser of:

The lesser amount is $60,000 so this becomes the capital gains reserve. The capital gain to be reported in the current year is $80,000 - $60,000 or $20,000.

Next year we must add back the reserve claimed this year and then calculate the reserve amount again. As Mr. X has received $30,000 more from the sale, the calculation of the reserve will be the lesser of:

The lesser amount is $48,000 so we add last year's reserve of $60,000 and deduct the current reserve of $48,000 for a capital gain of $12,000 in the current year.

This process would be repeated until the full $80,000 capital gain has been reported. You should note that even if sale proceeds are not received within 5 years from the year of disposition, part (b) of the formula will cause the maximum reserve to be zero four years after the year of disposition. Or, stated another way, part (b) of the formula ensures that 1/5 of the capital gain must be reported every year for a 5 year period. Thus, it is not possible to spread a capital gain over more than 5 years by claiming a reserve. If the sale proceeds are received in less than 5 years, part (a) of the formula will cause the gain to be reported in full by the time total proceeds have been received.

There is an exception to the rule that a capital gain cannot be spread over a period greater than 5 years. The exception relates to property that is disposed of to a child of the taxpayer if the child was resident in Canada immediately before the disposition and the property was:

• land or depreciable property in Canada that, immediately before the disposition, was used by the taxpayer, his spouse, or any of his children in the business of farming.
• a share of the capital stock of the taxpayer's family farm corporation, or an interest in the taxpayer's family farm partnership.
• a share of the capital stock of the taxpayer's small business corporation.

For these types of property, the capital gain may be spread over a 10 year period provided the sale proceeds are not received in less than 10 years. The calculations of the maximum reserve amount each year is the same as shown above except that in part (b), 9 is substituted for 4.

A couple of points before we continue:

• a reserve is only permitted if the taxpayer is resident in Canada at the end of the taxation year. If a taxpayer who has been deferring the reporting of a capital gain from a previous year by claiming a reserve ceases to reside in Canada, his reserve in that year is zero and the balance of the unreported capital gain must be reported.
• capital gains realized on the sale of qualified farm property or qualified small business corporation shares which have been deferred by claiming a reserve will qualify for the $500,000 capital gains exemption when they are eventually reported.

Principal Residence

While the general rule is that capital gains are taxable, a special exemption applies in the case of a gain on the disposition of a principal residence. A principal residence is defined as any accommodation owned by the taxpayer (either alone or jointly) and ordinarily inhabited by him, his spouse or former spouse, or child. The accommodation can take any of several forms, such as a house, farm, condominium or a share in a co-operative housing corporation. A principal residence will include not only the building but also the land on which it is located, usually up to a limit of 1/2 hectare - although Revenue Canada has indicated that it will give favorable consideration to larger lots if the minimum lot size under an applicable zoning by-law was greater than 1/2 hectare when the property was purchased. For additional land to be treated as part of the principal residence, the owner must establish that it is "necessary to the use and enjoyment of the housing unit as a residence".

If a taxpayer owns 2 properties, only one of them may be designated as his principal residence for a particular year. Where a husband and wife own their home jointly, each will have to designate his or her share of the property as a principal residence for the eventual gain on re-sale to be exempt from tax.

The designation of property as a principal residence need not be declared from year to year, but only when the property is disposed of and then only if a taxable gain results. To determine if a taxable gain will arise, the taxpayer calculates the gain (proceeds minus the sum of cost base plus costs of disposition) as with any capital property. A deduction for a principal residence is then calculated using the following formula:

Often this will result in the entire gain being exempt. The "plus one" factor in the numerator of the formula is an arbitrary bonus feature to allow for the situation in which an individual sells a house and buys another in the same taxation year. No portion of the gain will be taxable unless the property failed to qualify as a principal residence in more than one taxation year after 1971. For each year designated as a principal residence, the property must qualify under the definition of a principal residence (as noted above) and the taxpayer must have been a resident of Canada at some time during each of those years.

Until 1982, one spouse could own and designate the family's usual home as a principal residence, and the other spouse could designate another property, provided each property met the test of being "ordinarily inhabited" by the owner. A seasonal residence, such as a summer cottage, would apparently meet the "ordinarily inhabited" test unless the principal reason for owning it was to produce rental income.

To put a stop to the practice of a married couple or a family owning and designating more than one property as a principal residence for a particular year, a 1981 amendment (effective 1982) to the Income Tax Act prevents a taxpayer from designating a property as his principal residence if any other property has been designated for that year by him, his spouse (unless separated) or any of his children (unless they are over 18 years of age or married).

So what happens with the summer cottage that qualified and was designated by the spouse as a second principal residence prior to 1982? The Act sets a cut-off point at December 31, 1981 and requires calculation of capital gain on disposition as if the property had been purchased for fair market value at the end of 1981. Thus, if the property can no longer be designated as a principal residence because of the restriction on designating second properties, any increase in value after 1981 will be subject to capital gains treatment. Any increase in value while designated as principal residence from date of acquisition to the end of 1981 will be exempt from tax.

a) Change of Use of a Principal Residence

An election is available under Sec. 45(2) of the Act when an individual moves out of his principal residence, rents it out and later re-occupies the property. This election avoids a deemed disposal at fair market value when the principal residence becomes a rental property and a second deemed disposal when the property is re-occupied and again becomes a principal residence. When the election is filed, the taxpayer may designate the property as his principal residence for up to 4 years, even though he didn't live in it, provided he remains resident in Canada and does not designate some other property as his principal residence. The only restriction is that while the election is in effect, no capital cost allowance may be claimed to offset any rental income received.

Beyond the 4 years, the "no change of use" election continues to apply, unless revoked by the taxpayer, but the principal residence designation normally ceases. If the property is later disposed of, part of the resulting gain may be taxable.

The Act provides an extension of this rule, permitting the principal residence designation to continue beyond 4 years in cases where a person or his spouse is transferred by an employer and later returns to re-occupy the home not later than the year following the year in which employment with that employer terminates.

If a taxpayer fails to file the election under Sec. 45(2) in the year the change of use from principal residence to rental property occurs, Revenue Canada will accept a late-filed election (in the form of a letter indicating that it was the taxpayer's intention not to have the property treated as a rental property) provided no CCA has been claimed in the meantime.

It is important to remember that the Sec. 45(2) election can only be made when the property was previously a principal residence and then started to be rented out. If the property was purchased as a rental property and then later occupied by the owner, a deemed disposition at fair market value occurs at the date the property ceases to be a rental property. This deemed disposition can be deferred, however, by an election under Sec. 45(3) of the Act. If this election is made, any capital gain or loss accrued while the property was used to earn income is deferred until the property is actually disposed of. And, if the election is made, the Act permits the property to be designated as the taxpayer's principal residence for up to 4 years prior to the year in which it was actually occupied by him. The election under Sec. 45(3) is prohibited, however, if any CCA has been claimed on the property after 1984.

b) Principal Residence Rule For Farm Homes

A special rule applies to the sale of a principal residence which is a farm home. Normally, only 1/2 hectare of the farm land on which the residence is located may be included in the exempt portion of the disposal. Because farm properties are normally larger than this, and the "necessary to the use and enjoyment" test (as discussed above) is often hard to apply, farmers are given an alternative to segregating the principal residence portion from the rest of the farm. The farmer may elect to report the capital gain from the sale of the entire property, minus $1,000 for each year of ownership (plus one) after 1971 for which the property was his principal residence and during which he was resident in Canada.

For example, assume that a farm purchased in 1940 for $20,000 was sold in 1996, and that the fair market values of the property were as follows:

Under the "normal" principal residence rule, the capital gain for tax purposes would be calculated as follows:

Using the alternative method of calculating the principal residence portion, the capital gain calculation would be as follows:

The alternative method has reduced the capital gain by $16,000. This may not seem important where the gain would be sheltered by the lifetime capital gains exemption of $500,000 on the sale of qualified farm property, but if another farm is purchased (or qualified small business corporation shares) by the taxpayer, the alternative calculation has made $16,000 more of capital gains exemption available for future dispositions.

Personal-Use Property

Personal-use property is any property that is owned by the taxpayer and used primarily for his enjoyment, or for the use or enjoyment of one or more individuals related to the taxpayer. Many items of personal-use property are assets that depreciate through use, such as a car, a boat and various items of furniture. A second home or summer cottage that is not rental property would also be considered personal-use property.

Gains on disposals of personal-use property are taxable the same as other capital gains, but capital losses on such property are not deductible, even to offset personal-use property gains.

To eliminate the nuisance factor involved in keeping track of gains and losses on small items, the Income Tax Act provides a $1,000 "floor" rule for personal-use property. Thus, when calculating a capital gain on personal-use property, the adjusted cost base is deemed to be the greater of ACB or $1,000. Similarly, proceeds of disposition are deemed to be the greater of actual proceeds or $1,000. To illustrate, suppose the taxpayer sold a personal-use property for $1,200 and his ACB was $500. The greater of actual proceeds or $1,000 is $1,200. The greater of ACB or $1,000 is $1,000. Thus, the capital gain is $200.

If the personal-use property was sold for $900 and had an ACB of $1,500, the deemed proceeds would be $1,000 as this is greater than actual proceeds. The capital loss is $500 but remember that capital losses on personal-use property are not deductible - even against capital gains on personal-use property.

Where both proceeds and ACB are less than $1,000, no capital gain or loss can arise since both deemed proceeds and deemed ACB will be the same amount - $1,000.

Listed Personal Property

Listed personal property includes only the following items of personal-use property:

• a print, etching, drawing, painting, sculpture or similar work of art
• jewelry
• a rare folio, rare manuscript or rare book
• a stamp
• a coin

Because listed personal property is a form of personal-use property, the $1,000 floor rule applies as discussed above. After applying the floor rule, capital gains are taxed as normal. The difference to personal-use property is that capital losses realized on the disposition of listed personal property are deductible against capital gains - but only capital gains realized on disposition of other listed personal property. If listed personal property losses exceed gains on such property for the year, no deduction is permitted against other income or ordinary capital gains, but the excess may be carried over to apply against listed personal property gains of other years. The carryover period for listed personal property losses is 3 years back and 7 years forward.

Deemed Dispositions of Capital Property

1. Death - refer to Chapter 6 for complete details.
2. Leaving Canada - refer toChapter 4 for complete details.

Capital Losses

Prior to 1985, allowable capital losses (3/4 of the capital loss) were first netted against taxable capital gains for he year and any excess was deductible against other income to a maximum of $2,000 per year. Allowable capital losses realized after May 22, 1985 may be applied only to offset taxable capital gains, either in the same year or on a carryover basis. We'll cover the carryover of capital losses shortly.

Allowable Business Investment Losses (ABIL)

An allowable business investment loss is defined as the deductible portion of a capital loss on the disposition of shares of a small business corporation or a debt owing to the taxpayer by a small business corporation - if the property has been disposed of to someone dealing at arm's length with the taxpayer.

A small business corporation is defined as a Canadian-controlled private corporation substantially all of the assets (90%) of which are either used in an active business carried on primarily in Canada by the corporation or a corporation controlled by it.

The business investment loss rules also apply to losses incurred on shares where the corporation becomes bankrupt during the year and on certain debts established to have become bad debts (uncollectible) during the year.

An ABIL (3/4 of the business investment loss realized) is, unlike other capital losses, deductible against other income for the year. If the ABIL exceeds other income earned during the year, it may be carried back up to 3 years and then, if still unused, carried forward seven years. If the ABIL is still unused after this period it may be carried forward indefinately but only to offset taxable capital gains.

Carryover of Capital Losses

Earlier, we saw that an allowable capital loss is the deductible portion of a capital loss, and that such amounts may be offset against taxable capital gains arising in the same year. Where capital losses exceed capital gains in a year, the excess net capital loss may first be carried back 3 years to offset capital gains. If net capital losses still exist, the amount may then be carried forward indefinitely to offset capital gains of future years.

When a taxpayer with unused net capital losses dies, those losses are first reduced by the total of the capital gains exemption previously used by him in previous years (including the former $100,000 exemption). The excess, if any, of allowable capital losses may then be deducted against other income in the year of death. To illustrate, suppose a taxpayer with $20,000 of unused capital losses dies in 1996. He has previously used only $14,000 of his lifetime capital gains exemption. We would first reduce his $20,000 of unused capital losses by the $14,000 of capital gains exemption claimed. The remaining unused capital loss is $6,000 of which 3/4, or $4,500 may be deducted against other income for the year of death. If income in the year of death was less than $4,500, the excess allowable loss may be carried back to offset income in the immediately preceding year.

Cumulative Net Investment Loss (CNIL)

Since the beginning of 1988, any CNIL accumulated must reduce the available $500,000 capital gains exemption to a taxpayer. The purpose of this reduction is to prevent an individual from deducting investment expenses which exceed investment income and then sheltering capital gains fully via the capital gains exemption. The term "CNIL" is defined as the amount by which the aggregate of investment expenses exceeds the aggregate of investment income for all taxation years after 1987.

Investment income include the following amounts:

• interest, taxable dividends and other income derived from property belonging to the individual, a partnership of which he is a "specified member", that is, a limited partner or a partner that does not have an active role in the partnership.
• income from rental and leasing properties that belong to the individual or to a partnership of which he is a member.
• recaptured capital cost allowance
• 1/2 of the income derived from the recapture of exploration and development expense.
• Investment expenses include the following items:
• amounts deducted (including interest) by the individual in computing the income from property that are mentioned above but excluding deductions claimed in respect of indebtedness incurred (prior to November 13, 1981) for the purposes of buying a RRSP or Income Averaging Annuity Contract.
• loss from rental and leasing properties that belong to the individual or a partnership of which he is a member.
• interest and financing costs deducted in computing the income of the partnership of which the individual is a "specified member".
• any portion of a loss that is allocated by a partnership of which the individual is a specified member.
• 1/2 of any amounts deducted for exploration and development expenses that have been allocated by a corporation (flow-through shares) or a partnership of which the individual is a "specified member".

Here is an example of how the CNIL rules work. Mr. X has never used any of his $500,000 capital gains exemption. In January 1988, he borrows $50,000 at 10% annual interest to invest in a growth oriented investment which produces a 2% annual cash dividend. We'll ignore fees so that investment is worth $50,000 at date of purchase. We'll also assume that Mr. X has no other investment income or rental income.

From the beginning of 1988 onward, Mr. X.'s CNIL balance increases by $3,750 annually. This figure is arrived at by adding tax deducted interest expenses of $5,000 ($50,000 x 10%) and deducting grossed-up dividends of $1,250. No disposition of capital property by Mr. X. occurs from 1988 to the end of 1995 so his CNIL balance at the end of 1995 is $30,000 ($3,750 each year for 8 years).

At the end of 1996, Mr. X sells shares of a qualified small business corporation for $200,000. Once again he has deducted $5,000 of loan interest and reported $1,250 of taxable dividends on his 1996 tax return. Thus, CNIL has increased by a further $3,750 to a cumulative total of $33,750 at the end of 1996.

The next step is to calculate Mr. X's taxable capital gain on the disposition of his shares. Assuming the shares have an ACB of $150,000, the capital gain is $50,000 of which the taxable portion is 3/4 or $37,500. From the taxable gain we deduct the CNIL balance of $33,750. The remainder of $3,750 is the amount of taxable gain which qualifies for the taxable capital gains deduction of $375,000. It is very important when considering CNIL to think in terms of the taxable capital gains deduction rather than the "gross" exemption of $500,000. The remaining taxable capital gain of $33,750 must be reported on Mr. X's 1996 tax return. The amount of taxable capital gain to be reported in the year of disposition is equal to the amount of the cumulative CNIL balance.

Again, the system is designed to ensure that if your cumulative investment expenses after 1987 exceed your cumulative investment income after 1987, the amount of the excess of investment expenses will not be sheltered by the $500,000 capital gains exemption when a gain is realized. The system is exactly the same as CCA and recapture on depreciable assets. Each year, you are allowed to claim CCA as a deductible expense but when the asset is sold, previously claimed CCA is added back into income as recapture. The excess of investment costs over investment income is analogous to CCA. You can deduct the investment costs each year, but when you realize a taxable capital gain the amount of the excess of investment costs over investment income will be "recaptured". Revenue has effectively ensured that investment costs don't become an absolute tax saving where gains are sheltered by the $500,000 capital gains exemption, but rather a tax deferral item whereby you get a tax deduction each year as expenses are incurred, but the recapture occurs only when a capital gain is realized. The CNIL system puts the individual in the same economic position as prior to the introduction of the capital gains exemption.

Let's get back to Mr. X. Because his entire $33,750 CNIL balance was "recaptured" at the end of 1996, the balance reverts to zero at the beginning of 1997. The rule is that the amount of recaptured CNIL is credited against the cumulative balance in the CNIL account. To illustrate, suppose Mr. X had sold his shares for $170,000 rather than $200,000 in my example. His taxable capital gain would be 3/4 x $20,000 or $15,000. From this we deduct CNIL of $33,750 and determine that none of the $15,000 taxable gain qualifies for the deduction. The CNIL balance at the end of 1996 is $33,750 but is reduced by the $15,000 of recaptured CNIL for a balance of $18,750 at the beginning of 1997.

Some final points regarding CNIL:

• if the individual does not hold qualified small business corporation shares or qualified farm property, or has fully utilized his $500,000 capital gains exemption, CNIL is irrelevant.
• an individual whose post-1987 investment income exceeds post-1987 investment expenses will be building up a "debit" balance in his CNIL account. For example, Mr. Y reports $5,000 of investment income on each of his tax returns from 1988 to 1995 inclusive. He has a negative or debit balance of $40,000 in CNIL at the end of 1995. As such, he could incur $40,000 of investment expenses in excess of investment income after 1995 without being affected by CNIL. The key point is that CNIL does not have to be a positive balance. Where post-1987 investment income exceeds post-1987 investment expenses, CNIL will be a negative amount and will have no effect on the capital gains deduction. The cumulative CNIL balance, whether positive or negative, is calculated on form T936. The T936 must be filed whenever a taxpayer claims the $500,000 capital gains exemption.

Conclusion

By now you are no doubt convinced that my comment at the beginning of the chapter regarding the complexity of the taxation of capital gains and losses, was indeed true. You now, however, have a reference guide available to help you with questions and strategies relating to this area.