CHAPTER SEVEN

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CHAPTER SEVEN

• Gains and Losses on the Disposition of Capital
  Property Capital Gains
• I. Capital Gain and Capital Loss Defined
• II. Determining Capital Gains and Losses
  General Rules
• III. Unique Aspects of Capital Losses
• IV. Unique Aspects of Specific Capital
  Properties
• V. The Aggregating Formula Revisited
• VI. Impact on Investment and Management Decisions

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I. Capital Gain and Capital Loss Defined

• A capital gain (loss) is the gain (loss) realized
  on the disposition of capital property.
• For a property to be classified as capital
  property, it must have been acquired and used for
  the purpose of providing the owner with a
  long-term or enduring benefit.
• The key is establishing the intended purpose of
  the acquisition as the definition does not
  require that it actually be held for the
  long-term or that it must provide a benefit.

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Capital vs. Business Income

• The sale of property by any taxpayer can be
  classified as a business activity or as a capital
  transaction it depends on the intended purpose
  of acquiring the property.
• The nature of the asset is not relevant since the
  same property may be capital property to one
  taxpayer and inventory, part of a business
  activity, to another.

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Intention

• There are four factors which should be taken into
  account together in establishing the taxpayers
  original intention
• Period of ownership
• Nature of the transaction
• Number and frequency of the transactions
• Relation of transaction to taxpayers business

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Period of Ownership

• That a property is held for a long period of time
  substantiates the claim that it is capital
  property which was purchased to provide a
  long-term and enduring benefit.
• That a property is held for a short period of
  time speaks against such a claim, in that it is
  evidence that the property may have been
  purchased for resale.

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Nature of the Transaction

• The courts will examine the entitys course of
  conduct over the ownership of the property,
  dwelling on the point of acquisition, the use of
  the property during its ownership, and the
  reasons for and nature of its disposition.

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Number and Frequency of Transactions

• A historical pattern of frequent buying and
  selling supports the premise that the intended
  purpose of acquisition was to resell at a profit.

8
Relation of Transaction to Taxpayers Business

• If the property sold is similar in nature to
  property normally dealt with as part of the
  owners trade or occupation, it is difficult to
  establish that the ownership of such property was
  of a capital nature.

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Change in Purpose

• Property that was acquired to provide a long-term
  benefit and has been used for that purpose may,
  at some point, be converted into inventory and
  held for the purpose of resale.
• Similarly, property that was acquired as
  inventory for resale, may, if not sold, be
  converted to capital property and used to produce
  income.
• CCRA has Change in Use policy which requires
  that the gain or loss be allocated between
  capital and business income in accordance with
  the propertys value at the time the purpose
  changed.

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Canadian Securities

• Investments in marketable securities almost
  always have a dual purpose to generate annual
  returns and to realize a profit on resale.
• Historically, CCRA has applied the common law
  principles described previously in a lenient
  manner.
• The Act permits a taxpayer to elect to have all
  sales of Canadian securities treated as capital
  transactions.

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Canadian Securities Continued

• A Canadian security is considered to be a share
  of the capital stock of a resident Canadian
  corporation, a unit of a mutual fund, or a bond,
  debenture, bill, note, mortgage, or other similar
  obligation issued by a resident of Canada.
• While choosing this election ensures capital
  treatment of all security transactions, it also
  locks the investor into using this method
  indefinitely.
• This may not always be desirable - losses will be
  capital losses and, thus, only deductible against
  capital gains.

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Categories of Capital Property

• The Act defines three categories of capital
  property
• Personal use property
• Listed personal property
• Financial property

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Personal Use Property (PUP)

• Property owned by the taxpayer that is used
  primarily for the personal use or enjoyment of
  the taxpayer, or persons related to the taxpayer,
  and that does not generate financial returns.
• Ex. A car, a house, furniture

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Listed Personal Property (LPP)

• Property in this category includes items that are
  for personal use but also have some element of
  investment value. Includes
• A print, etching, drawing, painting, or
  sculpture, or other similar works of art
• Jewellery
• A rare folio, rare manuscript, or rare book
• A stamp
• A coin

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Financial Property

• Includes all capital property that was acquired
  primarily to generate a benefit through a
  financial reward.
• Includes shares, bonds, loans, land, buildings,
  equipment, patents, licences, franchises, and
  vehicles.

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II. Determining Capital Gains and Losses
General Rules

• The capital gain (loss) is calculated by
  deducting the adjusted cost base (ACB) and
  expenses of disposition from the proceeds of
  disposition.
• The taxable capital gain (allowable capital loss)
  is one-half of the capital gain (loss).

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Disposition and Proceeds of Disposition

• Capital gains and losses are only recognized for
  tax purposes when a disposition of the property
  occurs.
• A disposition of property occurs when
• Property is sold
• Property is involuntarily eliminated by theft,
  destruction, or expropriation
• A share, bond, debenture, note, or similar
  property is cancelled, redeemed, or settled or,
• A share owned by a taxpayer is converted by
  amalgamation or merger.

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Sale of property

• When property is sold, the proceeds of
  disposition is the selling price.
• Property that is sold in exchange for other
  property has proceeds of disposition equal to the
  FMV of the property received in exchange.
• The proceeds of disposition for an involuntary
  disposition is the compensation received for
  stolen, destroyed, or expropriated property.

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Deemed Disposition

• In some circumstances property is deemed to be
  disposed even though no proceeds of disposition
  are received. In the following cases deemed
  disposition is valued at FMV with limited
  exceptions
• Gift
• Change in use
• Giving up residency
• Death

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Adjusted Cost Base (ACB)

• Normally the ACB original purchase price plus
  other costs incurred to make the acquisition
• That Act lists, in section 53, a number of
  specific additions to and deductions from cost
  that can be made to arrive at the ACB of a
  property.

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Expenses of Disposition

• All costs incurred to complete the disposition
  are deductible when arriving at the capital gain
  or loss
• Ie legal fees to complete the sale agreement,
• brokerage fees or commissions to agents,
• advertising, and mortgage discharge fees.

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Deferred Proceeds

• In order to facilitate a sale, a vendor may act
  as the financer for the purchaser by accepting
  payment in the form of an immediate down payment
  in cash, with the balance, with interest, to be
  paid over some future time period.
• When this occurs, the capital gain rules permit
  the vendor, subject to a time limitation, to
  recognize the taxable capital gain over a period
  of years in proportion to the receipt of the
  proceeds of disposition.

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Deferred Recognition of Gain

• The deferred recognition of capital gains is
  restricted to a maximum of five years, and a
  minimum of 20 of the capital gain must be
  recognized, on a cumulative basis, for each of
  the five years.
• Deferring the recognition of the capital gain to
  future years in proportion to the receipt of the
  proceeds is referred to as a reserve.

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Capital Gains Reserve

• The reserve is deducted from the taxable capital
  gain in the year to arrive at the taxable amount.
• The reserve is a discretionary deduction.
• The maximum reserve in any year is equal to the
  lesser of
• Deferred proceeds / Total proceeds x Taxable
  gain or
• 80 of the gain in year 1, 60 in year 2, 40 in
  year 3 20 in year 4 and 0 in year 5.

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III. Unique Aspects of Capital Losses

• Capital losses are only recognized when a
  disposition occurs.
• Capital losses can only be deducted for tax
  purposes to the extent that capital gains were
  realized in the same year.
• If a capital loss cannot be used in the current
  year, it can be carried forward indefinitely and
  used in the future when a capital gain occurs or
  it can be carried back to the previous three
  years provided that capital gains were incurred
  in those years.

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Allowable Business Investment Loss (ABIL)

• An ABIL is the allowable capital loss incurred on
  the disposition of a loan to a small business
  corporation, or on a sale of that corporations
  shares.
• A small business corporation is a private
  corporation that is Canadian-controlled and that
  uses all or substantially all of its assets (at
  least 90) to conduct an active business.
• When such a loss occurs, the aggregating formula
  permits it to be offset against all other sources
  of income derived by the taxpayer, as an
  exception to the normal capital loss rules.

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Deemed Disposition on Loans and Shares

• The rule that a capital loss can only be
  recognized when the property is disposed of is a
  burden to taxpayers when a market is not
  available for the sale of the property.
• In recognition of this, property that is a loan
  or a share of capital stock of a corporation is
  subject to deemed disposition rules that permit
  the loss to be recognized before an actual
  disposition occurs.

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Deemed Disposition Shares/Loans

• When an outstanding debt of a corporation is
  established to be a bad debt, the loan can be
  deemed to be disposed of for a value of nil and,
  thus, trigger a capital loss before the debt is
  actually disposed of.
• There is a similar provision for shares of a
  corporation but the deemed disposition cannot be
  triggered until the corporation has become
  legally bankrupt or equivalent.

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Depreciable Property

• It is impossible to have a capital loss on the
  disposal of depreciable property.
• The original cost of depreciable property is
  written off through the CCA system.
• Therefore, any loss arising when property is sold
  for a price less than its original cost is
  automatically reflected in the annual CCA
  calculation or the terminal loss or recapture, if
  any.

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Superficial Losses

• When a capital property is disposed of for a loss
  and then reacquired within 30 days (before or
  after the date of disposition), the resulting
  loss is classified as a superficial loss, and
  deemed to be nil for tax purposes.
• The actual loss is not permanently denied, but
  rather is added to the ACB of the reacquired
  asset and will be recognized when the new
  property is sold.
• The same rule applies when the asset is sold to a
  related corporation or transferred by an
  individual to his/her RRSP.

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Personal Use Property

• For tax purposes, any loss suffered on the sale
  of personal use property is deemed to be nil,
  even though gains on such property are taxable.
• This restriction is applied to each item of
  personal property.
• Personal use property has a deemed minimum cost
  for tax purposes of 1,000 and deemed minimum
  proceeds of 1,000.

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Listed Personal Property

• Losses on LPP are recognized, but they are only
  deductible against gains on LPP.
• To the extent that capital losses on LPP cannot
  be used in the current year, the unused loss can
  be carried back three years or forward seven
  years and deducted against LPP gains, if any, in
  those years.
• Each item of LPP has a deemed minimum cost for
  tax purposes of 1,000 and deemed minimum
  proceeds of 1,000.

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IV. Unique Aspects of Specific Capital Properties

• Certain specific types of property require
  special mention either because the tax treatment
  deviates from the general principles of capital
  gains or because it is difficult to establish
  whether or not the property is capital property.

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Identical Properties

• Often several properties of an identical nature
  are acquired over a period of time and at
  different costs. For example Shares of Nortel
• The ACB of each identical property acquired is
  the weighted average cost of all the identical
  properties acquired up to the point of sale.

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Principal Residence

• A principal residence can generally be regarded
  as a housing unit owned, either directly or
  through a cooperative, by the taxpayer and
  ordinarily inhabited for personal use.
• A principal residence is personal use property
  as such, it may be subject to a capital gain on
  sale, but it cannot realize a capital loss.

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Calculation of Principal Residence Exemption

• The capital gain realized on the sale of a
  principal residence is reduced by the following
  formula

1 Yrs. Designated Principal Residence X
Gain Number of Years Owned
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Exemption Rules

• If a taxpayer owns more than one personal
  residence, only one can be designated for any
  particular year.
• Only one property can be designated for each
  family (husband and wife).
• The 1 is included in the formula to cover the
  year in which two houses are owned as a result of
  the normal process of selling one house and
  acquiring a new one.

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Real Estate Used to Carry on a Business

• If the replacement is voluntary and the real
  estate is replaced by the end of the taxation
  year following the year of disposition, the gain
  will reduce the ACB of the replacement property.
  This exception does not apply to real estate used
  to earn property income from rentals.
• If the replacement is involuntary, such as
  expropriation, and the real estate is replaced by
  the end of the second taxation year following the
  year of disposition, the gain will reduce the ACB
  of the replacement property.

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Involuntary Disposition

• If the replacement is involuntary, such as
  expropriation, and the real estate is replaced by
  the end of the second taxation year following the
  year of disposition, the gain will reduce the ACB
  of the replacement property.
• Neither of the exceptions apply to personal use
  real estate.

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Mutual Funds

• Units of a mutual fund are capital property the
  purchase price represents the units ACB for tax
  purposes.
• Distributions from the mutual fund retain the
  source and characteristics of the income earned
  by the mutual fund capital gains, dividends,
  interest, and ordinary income and are included
  in each unit holders income for tax purposes in
  the taxation year of the distribution.

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Disposition of Mutual Funds

• When the distribution is reinvested by acquiring
  additional units of the mutual fund, it is still
  taxable to the unit holder as capital gains,
  dividends, interest, or ordinary income, and the
  total amount of the distribution is added to the
  ACB of the investment.
• A disposition for tax purposes occurs whenever
  all or some of the units are redeemed for cash or
  transferred to another mutual fund.
• The disposition will result in a capital gain or
  loss to the extent that the redemption price or
  transfer value varies from the ACB of the units
  at the time.

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Special Situations

• 1994 Capital Gains Exemption Election
• Deemed disposition if election filed to take
  advantage of 100,000 exemption
• Pre 1972 CG system
• 1971 Valuation day- Median Rule or V-Day Value
• Median or Middle of
• Actual Cost
• V D Value
• Proceeds of Disposition

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VI. Impact on Investment and Management Decisions

• The influence of the tax treatment of capital
  properties on investment and management decisions
  centres on the fact that preferential treatment
  is given to capital gains, regarding the amount
  taxable and the timing of income recognition
  whereas restricted treatment is given to the
  utilization of capital losses.