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Capital gains vs. income

One of the more common income tax matters that Moodys LLP Tax Advisors advises on is whether or not a disposition (or a proposed disposition) of property will result in a capital gain (half of which is taxable), or will be fully taxed as income. Taxpayers often take for granted that dispositions of property will be treated as capital gains.

Prior to 1972, capital gains were not taxable in Canada. Accordingly, there were many tax positions taken by taxpayers that dispositions of property were capital gains. After 1971, capital gains became half taxable and in subsequent years the capital gains inclusion rate increased from 50% to 23 to 34, but in recent years has once again declined to 50%. Accordingly, there is usually a significant tax advantage for characterizing a profitable disposition of property as a capital gain.

The determination of whether a gain is on account of capital or on account of income is not as easy as it may seem. The courts have struggled with this concept for decades. It is not the intention of this blog entry to explain the factors (which would be lengthy) which must be considered when determining whether a gain is on account of capital or on account of income. Notwithstanding, one of the main factors that is looked at by the courts is the original intention of the taxpayer for acquiring the property. To the extent that the taxpayer’s original intention was to ultimately dispose of the property for a profit, then the courts will often determine such a profitable disposition to be on account of income.

A common example of this is the disposition of residential properties. The so called “house hopper” will often live in a home for a short period of time, dispose of it for a profit, acquire another property, dispose of it for a profit, and so on. Such a person will often take the position that each property disposed of qualified as a principal residence, and therefore, is not subject to taxation. However, in order to qualify for the principal residence exemption, the original, and each subsequent disposition must have been on account of capital and not on account of income. In many cases, the disposition of homes by house hoppers may be considered to be on account of income, thereby negating the use of the principal residence exemption and causing full taxation on any profits.

A recent case, while not an unusual case, highlights the CRA’s awareness when determining whether or not dispositions of property are on account of income or on account of capital. The case of 1338664 Ontario Limited v. Her Majesty the Queen was released on June 12, 2008. The issue in question was whether the disposition of securities by 1338664 Ontario Limited should be on account of income or on account of capital. The sole shareholder of 1338664 Ontario Limited was a fellow by the name of Gus George. On the advice of his accountant, Gus transferred a portfolio of securities into the corporation. For the 2001 and 2002 taxation years of 1338664 Ontario Limited, the only activity of the corporation was buying and selling securities. It appears that Gus conducted his own research and provided instructions to brokers to buy and sell publicly traded securities on behalf of the company. The corporation conducted over 200 transactions in each of its 2001 and 2002 taxation years. Accordingly, the CRA reassessed 1338664 Ontario Limited for its 2001 and 2002 taxation years to recharacterize the previously recorded capital gains of over $300,000 in each year as business income.

In the decision, the judge analyzed the sophistication of Gus, the number of trades, the length of time that the securities were held and the time spent on trading activities by Gus. After citing the usual precedents on such matters, the judge rendered a decision that 50% of the gains were on account of income and the other 50% were on account of capital. Interestingly, the judge noted that there was not a satisfactory rationale for the 5050 split between capital and income except that it did appear to be a rough division of the securities held for less than one week.

Again, as noted, the decision in 1338664 Ontario Limited is not all that enlightening but it does serve as a gentle and current reminder that taxpayers must be aware of whether their dispositions of property should be accounted for as capital gains or income. There is no “bright line test” with respect to such a determination. Accordingly, when disposing of properties, such as securities and real estate, great caution should be excercised. Seek tax advice.