CHAPTERS SEVEN & EIGHT - CAPITAL GAINS: AN INTRODUCTION
(Div B, Subdiv c , S38-55)

HISTORY
Prior to 1972 capital gains were not taxed in Canada and capital losses could not be claimed.
The portion (inclusion rate) of a capital gain or loss which is taxable/deductible has changed since then. [calendar 1972 to 1987 => 50%; calendar 1988 to 1989 => 66.67%; calendar 1990 to Feb 27, 2000 => 75%; Feb 28 to Oct 17, 2000 => 66.67%; Oct 18, 2000 to present => 50%]

Since 1972, each disposition of capital property requires a separate calculation of taxable capital gain or allowable capital loss. Section 3(b) requires that allowable capital losses be offset against taxable capital gains, except as discussed below for PUP (including LPP) and ABILs. If the net result of all current year capital dispositions is a taxable capital gain, this amount is included in Division B income. If the net result is an allowable capital loss, this amount is not deductible currently since allowable capital losses can ONLY BE DEDUCTED AGAINST taxable capital gains. (A net allowable capital loss for the current year can be carried over to other years under Division C, as will be discussed in chapter 10.)

ABILs
Allowable Business Investment Losses are effectively allowable capital losses, resulting from the disposition of shares or debt of Small Business Corporations (CCPCs carrying on Active Business), which are deductible against any type of income. (ie not restricted to capital gains.) As such they are identified and segregated from the net taxable capital gain/loss computation for the year, and dealt with separately. This is effectively a tax incentive to motivate investors to invest in Canadian small businesses.

If an individual has previously claimed a capital gains deduction (anytime since 1985), any subsequent BIL is reduced (disallowed) by an amount equal to the capital gains previously sheltered by such deductions. This “disallowed” BIL is converted to a capital loss, and as such can only be deducted against capital gains. See page 318 in text. (The finance department feels that allowing individuals to offset taxable capital gains with the capital gains deduction, while also allowing other income to be offset by ABILs is “double dipping” and too generous! Similar restrictions are placed on claims for capital gains deductions where previous ABIL claims have sheltered other income sources from taxation.)

CAPITAL GAINS DEDUCTION
The general capital gains deduction allowing resident individuals (not corporations) to earn in their lifetime $100,000 of capital gains tax free, existed between 1985 and 1994. The deduction was claimable only in the year of a capital disposition which gave rise to a capital gain. In 1994 a final election to use any unused portion of the lifetime limit against unrealized gains which could be supported by FMV appraisals was allowed. The benefit of the election was to increase the ACB of capital assets which had increased in value but had not yet been subjected to a disposition. This election may still be relevant in tax preparation today, where a taxpayer disposes of property (say real estate) which was acquired prior to 1994 and on which an election had been made.

A further capital gains deduction allowing resident individuals to earn in their lifetime $800,000 (less any prior claims made under the general deduction above) of capitals gains tax free on the sale of qualified Small Business Corporation shares and qualified farming & fishing properties only, still exists today.

This deduction again represents a tax incentive to motivate investors to invest in Canadian small business and to assist farming & fishing operations.

CAPITAL VS INCOME RECEIPT
Recall from chapter 1 and the history above, that capital gains have always received favourable tax treatment. Therefore, the issue of whether or not a specific gain is on account of capital or some other form of income, is implicit in all dispositions. Review the concepts of PRIMARY INTENTION and SECONDARY INTENTION, including the various criteria used to establish INTENTION which were first introduced in chapter 4 and are discussed again in this chapter.
Note that a special election is available under S39 to individuals only, with respect to the disposition of “Canadian Securities”, to have all such transactions treated as capital in nature.
It should be obvious that taxpayers prefer capital gains treatment to income treatment on profits, but would prefer income treatment (100% deductible against any income) over capital gains treatment in the case of losses! IT-459, IT-218R, IT-479R are useful resources on this topic.

TERMINOLOGY
Capital property includes any depreciable property, and any other property that would result in a capital gain or loss on disposition (based on the common-law principles above.)

Rules related to the computation of net taxable capital gains refer to 3 classifcations of properties: Personal Use Property (property acquired for personal use and enjoyment of the taxpayer), Listed Personal Property (specific collectibles not expected to depreciate represent a specific subset of PUP) and Other Capital Property (the default classification which includes capital property acquired to generate income from business or property)

Proceeds of disposition less: Adjusted cost base less: Costs of disposition
= Gain or Loss less: Exemptions (S40 Reserve for amounts not yet due; Principal residence exemption)
= Capital Gain or Capital Loss times: Current year inclusion rate
= Taxable Capital Gain or Allowable Capital Loss.

Capital gains or losses are only computed at the time of disposition. For tax purposes dispositions include sales, but can also be “deemed” on change in use, death of the taxpayer, emigration of the taxpayer from Canada and on gifting of the asset to another taxpayer. ACB computations begin with accounting “laid-in cost” but may require adjustment for tax purposes in accordance with sections 52 and 53 and the ITAR’s (for assets acquired prior to 1972). The applicable inclusion rate is determined based on the date of DISPOSITION of a capital asset.

GAAR (General Anti-Avoidance Rule) under S245 provides CRA with significant potential powers to deal with various Tax Avoidance (chapter 1) schemes including those relating to capital gains.

The disposition of Depreciable Capital Property can give rise to capital gains, but can never result in a capital loss! This is due to the fact that a “loss in value” would be given a 100% deduction under the CCA system. (To allow a capital loss in addition, would be double counting this cost for tax purposes.)

CAPITAL GAINS RESERVES
S40 allows a reserve (temporary deduction or tax deferral) to be claimed where a portion of the total proceeds of disposition is “not due” until after the end of the current taxation year. The reserve is equal to the lesser of: a) a reasonable reserve = proceeds not yet due/total proceeds x gain on disposition, and b) (4 - number of prior tax years ending after the year of disposition)/5 x gain on disposition. The b) part of this formula ensures that a minimum cumulative capital gain of 20% per year is reported in any case. Thus the maximum period over which a capital gain may be apportioned under this reserve is 5 years.

Any capital gains reserve claimed in one year is included in income the following year as a gain. This ensures the integrity of the reserve system and allows a new reserve to be claimed the next year subject to the constraints of the formula.

PRINCIPAL RESIDENCE EXEMPTION
Gains on the disposition of a Principal Residence may be exempted by “Designating” the residence as such for specific years, and thus claiming the exemption.
Principal residence - any housing unit owned by the taxpayer outright or jointly and ordinarily inhabited (at least 24 hours in a year) by the taxpayer, his spouse or child at any time in the year.
- normally includes house and up to ½ hectare of surrounding land. (May include more than ½ hectare if land necessary to “use and enjoyment”. See IT 120R5)
Designation - only necessary to designate post-1971 calendar years, in the year of disposal.
- since 1981, only one property may be designated by any taxpayer’s family unit (includes spouses and unmarried minor children) in a given tax year. (1972 - 1980 one designation per year possible per taxpayer.)
- form T2091, exemption calculation, need only be filed if some portion of gain on disposition of residence sold remains taxable.
- taxpayer must be resident in Canada for tax purposes during any calendar year which is designated.
Exemption formula = (1 + # of calendar years designated)/(# of calendar years in which property owned) x gain.
Note: The exemption for principal residence can never exceed the gain to create say, a loss. Therefore there is no benefit to designating all years of ownership.

Algorithm to maximize the principal residence exemption where more than one eligible residence is owned:
1 - Calculate the gain per year for each eligible residence.
2 - Exclude from consideration any years of ownership which have previously been designated on prior disposition of other principal residences.
3 - Allocate any “no-option” years to the only eligible residence.
4 - Allocate the minimum years necessary to maximize the exemption for each property starting from the highest “gain per year” to lowest gain per year.
5 - Check if any property has not been designated at all, and if the total exemption can be improved by designating it for at least one year...and reducing the designation of another property.

PERSONAL USE PROPERTY
Property acquired primarily for personal use, as opposed to income earning use, most commonly results in capital losses on disposition. These losses are deemed to be personal or living costs and may not be used to offset capital gains for tax purposes. However, if a capital gain results on disposition it is taxable.
For purposes of capital gains calculations, the proceeds and the ACB of PUP is deemed to be the greater of actual proceeds (or ACB) and $1,000. This effectively excludes “smaller” PUP gains from taxation.

LISTED PERSONAL PROPERTY
This subset of PUP includes works of art, jewellery, rare books, stamps & coins.
Capital losses on disposition of LPP may be used to offset capital gains from LPP only. Similarly, net capital losses of LPP in any year may be carried back up to 3 years and forward up to 7 years to offset net LPP capital gains, under Division B.

POOLING OF IDENTICAL ASSETS
Tax issues arise in determining the ACB of specific identical assets when only a portion of those owned have been subjected to disposition. Determining the ACB of identical assets acquired over time at different prices is similar to the accounting problem of costing identical items of inventory in accounting. Stocks, bonds and mutual funds are the most common types of assets to which pooling would apply.
For tax purposes, identical assets must be grouped into a Pre-72 Pool and Post-71 Pool depending on the year of acquisition. Pre-72 Pool assets are deemed to be sold first and ACB is assigned on a FIFO basis. Post-71 Pool assets are allocated ACB on the basis of Floating Weighted Average Cost.

ACB ADJUSTMENTS UNDER S52 & 53
ACB begins with “laid-in” cost of acquisition, identical to accounting. Various adjustments to this cost base are required for tax purposes, where applicable.
The cost of inherited assets, dividends in kind or lottery prizes are deemed to be fair market value. This would be relevant in determining ACB on subsequent disposition.
Where an amount in respect of a property has been included in income under another tax provision, that amount is added to the ACB of the property. For example, stock dividends are usually taxable when received, similar to cash dividends. (The actual dividend is equal to the increase in PUC of the issuer corporation. This is often, but not always, the fair market value of the shares.) The amount of the actual dividend would be added to the ACB of the shares received.

On the exercise of employee stock options, the income inclusion under S7(1) would be added to the ACB of the shares acquired as we saw in Chapter 3.

Superficial loss rules attempt to defer the recognition of capital losses for tax purposes under a scheme known as “tax-loss selling”. This is achieved by denying some or all of a loss realized on a disposition and adding this same amount to the ACB of the remaining identical assets held.
For a disposition giving rise to a loss to be considered superficial:
1 - the taxpayer must dispose of property (usually shares or mutual fund units)
2 - the taxpayer must acquire the identical property during a period beginning 30 days before the disposition and ending 30 days after the disposition
3 - the taxpayer must own some of this property at the end of the period described in #2.

SECTION 3 ORDERING PROVISION:
3a) Aggregate net incomes (exclude any losses) from office and employment, business, property and other non-capital sources, plus
3b) Net taxable capital gains (all taxable capital gains excluding those from LPP, plus LPP net taxable capital gains, minus allowable capital losses excluding LPP losses and ABILs), less
3c) Other deductions under subd e (RRSPs, moving expenses, child care expenses, etc), less
3d) Losses of the current year from office and employment, business, property and ABILs.

COST OF ASSETS OWNED ON DECEMBER 31, 1971
The ITARs are transitional provisions, designed among other things, to eliminate gains and losses accrued prior to 1972, but realized after that date, from taxation.
ITAR 26(3) or the Median Rule applies automatically to all taxpayers. It establishes the ACB of non-depreciable capital property held on December 31, 1971 to be the median value of a) proceeds of disposition, b) V-Day value, c) cost.
As an alternative, individuals only, may elect to use ITAR 26(7) which establishes ACB of such property to be V-Day value. (Fair market value on December 31, 1971; December 22, 1971 for publicly traded securities) This election must be made the first time the two ITARs provide different ACB figures and must be used continuously thereafter.