Published: March 17, 2020
Last Updated: April 13, 2020
The Distinction Between Business Income and Capital Gain
When a taxpayer sells real estate, other than his or her principal residence, any gain realized will be treated as business income or capital gain. The distinction between the two, business income and capital gain, is very important for income tax purposes. Under the Income Tax Act, a taxpayer must report 100% of the gain on a disposition of property that is held for a business purpose. The tax treatment of business income contrasts with capital gains, wherein only 50% of the gain realized from the sale of capital property is taxable. Determining whether (or not) gains from the sale of real estate is business or capital is crucial for taxpayers as the discrepancy between the two often amounts to thousands of dollars in taxes.
The Definition of Business in the Income Tax Act
Generally speaking, when a taxpayer “habitually” carries out a transaction (such as engaging in the sale or purchase of real estate) allowing him or her to produce profit, this may constitute a “business” as defined in the Income Tax Act.
Subsection 248(1) of the Income Tax Act defines “business” as a “profession, calling, trade, manufacture or undertaking of any kind whatever” and it includes an “adventure or concern in the nature of trade.” Income from office or employment is excluded from this definition.
While Canada’s tax act defines “business” it does not provide a precise definition for “adventure or concern in the nature of trade” and so the courts have stepped in to attempt to clarify. On the one hand, the presence of an “adventure or concern in the nature of trade” does not imply that the taxpayer who is carrying on or has carried on an “adventure or concern” is doing so in a business context that is “in the nature of trade.” On the other hand, the aforementioned definition of “business” can cause an otherwise “isolated transaction” to constitute a business transaction, simply by falling into the definition. Needless to say, this is a complex area of law that requires detailed analysis and advice from an experienced Canadian tax lawyer.
Adventure in the nature of trade is a common law concept that is carefully crafted, and precisely designed, to determine whether (or not) the transaction in question (purchase or sale transaction for example) is of a “business nature” or of a “capital nature.” In its interpretation bulletin IT-459 on “adventure or concern in the nature of trade”, the CRA explains its position that where the phrase is used in the Income Tax Act, its application is subjective. Meaning, a determination of the existence of a transaction that constitutes a business “adventure or concern in the nature of trade” is based on the “degree of activity” and “each situation must be considered in light of its own circumstances”.
This article focuses on business income and transactions that constitute an “adventure or concern in the nature of trade” in the context of real estate. However, it is important to highlight that the concept of “adventure or concern in the nature of trade” is not limited to real estate transactions. This means that a non-real estate property that “cannot produce income but must be sold to produce profit” is likely to constitute a business transaction that is an “adventure or concern in the nature of trade”. There are many reported cases involving many different types of properties. Examples include Irrigation Industries Ltd. v. Minister of National Revenue where the property in question was shares from the treasury of a corporation and subsequent sale thereafter which created profit. As well, in two British cases, Rutledge v. C.I.R., 14 T.C. 490 the property in question was toilet paper and in C.I.R. v. Fraser, 24 T.C. 598 the subject property was whiskey.
How does a taxpayer determine whether (or not) the transaction in question is an “adventure or concern in the nature of trade”?
As previously mentioned, a taxpayer selling or purchasing real estate to produce profit on the sale is considered to be carrying on a business and will be required to report 100% of his or her business income for tax purpose.
But what if the taxpayer buys and or sells real estate once a year: does this constitute an adventure in the nature of trade? (and therefore, constitutes a business transaction) OR what if the taxpayer buys and or sells real estate once a month or even once a week: do any of these transactions constitute an adventure in the nature of trade (and therefore, constitute a business transaction)?
It should be clear by now that determining whether (or not) the purchase or sale of real estate is sufficient to constitute a business transaction may become more problematic when the transaction occurs less frequently, rather than habitually. Moreover, determining whether (or not) a transaction constitutes a business transaction can be problematic by the unequivocal definition in the Income Tax Act and will require advice from an expert Canadian tax lawyer.
Tax Case Law on “adventure or concern in the nature of trade”
In Friesen (J.) v. Canada the Supreme Court of Canada explained that the first requirement for an “adventure in the nature of trade” is that the transaction in question involves “a scheme for profit making”. Meaning that the evidence must clearly show the taxpayer’s intention to acquire profit as a result of the transaction in question.
Additionally in Friesen, the Supreme Court of Canada took the unusual step of referencing the CRA’s Interpretation Bulletin IT-459 “Adventure or Concern in the Nature of Trade” and Interpretation Bulletin IT-218 for a summary of other requirements that should be considered in determining whether (or not) a transaction creates business income or capital gain. The Supreme Court of Canada explained that the CRA’s list of requirements is not exhaustive. Interestingly enough, this is one of the few times that the Courts have essentially “codified” the CRA’s administrative position into the common law. As such, the CRA’s position carries much more weight with respect to this topic than others.
The CRA’s position on “adventure or concern in the nature of trade”
As previously mentioned, the CRA’s interpretation bulletin outlines a list of factors applicable by Canadian Courts in determining whether (or not) gain from the sale of real estate is considered as either business income or capital gain. These factors include:
(a) The taxpayer’s intention regarding the real estate at the time it was purchased.
- If the evidence shows that the taxpayer acquired the property with the intention of profit – the transaction is likely to constitute a business “adventure in the nature of trade.” However, evidence of intention for profit is not sufficient to constitute a business “adventure or concern in the nature of trade.” The taxpayer’s intentions must be clear that he or she acquired the property for the purpose of selling it for profit.
(b) Alternative and or secondary intentions.
- Canadian courts will also consider alterative or secondary intentions of the taxpayer (or another party engaged in carrying out the transaction – see comment (j) below) to acquire and or sell real estate for profit if the “main or primary intention is thwarted.
(c) The taxpayer’s conduct.
- This includes comparing the taxpayer’s actions and involvement in the transaction in question to another transaction of the same nature involving a dealer in such property. The Courts will also consider what would be expected of a dealer in relation to the property in question.
(d) The timeline during which the property was held by the taxpayer and the taxpayer’s conduct from the time the property is purchased, the time in which the taxpayer was in possession of it, to when it was sold.
(e) Taxpayer’s familiarity and experience in dealing with such property (or a property of a similar nature) in the nature of trade.
- This includes considering the nature of the taxpayer’s occupation and his or her previous involvement in real estate transactions.
(f) The nature of business, profession, calling or trade of the taxpayer.
(g) The nature of the property.
- Courts will explore whether (or not) the taxpayer acquired property that is capable of producing income, or whether it was purchased for his or her personal (and/or familial) enjoyment. For instance, if a taxpayer acquires property that he or she is incapable of using, except for the purpose of selling the property for profit – it is most likely that income from such a transaction will be treated as a business “adventure or concern in the nature of trade.” In contrast, where a purchased property is capable of being utilized for multiple purposes, other than being sold for profit, income from such property will likely be viewed as investment income and therefore the taxpayer will likely realize taxable capital gains on the date that the property is sold.
(h) Factors that motivated that real estate transaction in question.
(i) Financial aspects that are relevant to the transaction in question.
(j) Whether (or not) a person, other than the taxpayer, shares an interest in the property.
(k) Where the person mentioned in (j) above is present, Canadian courts will consider the nature of the person’s occupation, intention(s) and involvement in carrying out the transaction, as well as his or her previous involvement in real estate transactions.
This list is not conclusive. In determining whether (or not) the transaction in question creates business income or capital gains, Canadian courts have adopted a subjective approach wherein all the aforementioned circumstances ought to be considered. In summary, Canadian Courts will look at the nature of the transaction and the characteristics of each single transaction separately in applying the aforementioned requirements.
Real Estate Flipping
According to the CRA, property flipping is when “individuals, including real estate agents, buy or sell homes in a short period of time for profit”. This definition includes the purchase and sale of real estate that is bought and sold pre-construction, also known as “assignment sale”. The CRA outlines three categories of taxpayers engaged in property flipping:
- First, contractors and renovators who buy and sell real estate for profit.
- Second, middle investors who purchase real estate property before construction and sell or assign the right to sell it prior to its final closing date.
- Third, individual renovators who purchase real estate, renovate it, live in it for a short period of time and sell it for profit.
According to the CRA, there is a growing number of taxpayers engaged in property flipping who are incorrectly reporting their profits. That is, taxpayers are incorrectly reporting their flip profits as capital gains, rather than business income. Where the CRA determines that a transaction constitutes property flipping or assignment sale, all gains arising from the transaction in question are fully taxable and must be reported to the CRA.
Happy Valley Farms Ltd. v. Minister of National Revenue, sets out six key elements used to distinguish whether (or not) a property is acquired as an investment in the context of property flipping. If not, then any gain realized by the taxpayer on the sale of the property is treated as income for tax purpose. The six key factors are:
- Nature of the property sold
- Generally speaking, property that does not provide the taxpayer any “income or personal enjoyment” will likely have been acquired for the purpose of resale.
- Length of period of ownership
- In this context, the property is likely to be resold in a short period of time and a short period of time seems to suggest that business income is earned.
- Frequency or number of similar transactions by the taxpayer
- o A taxpayer conducting numerous similar transactions and or transactions of similar characteristics within a short period of time will likely be viewed as conducting business in real estate transactions.
- Work expanded or relatable to the property
- This includes efforts made by the taxpayer, during his or her possession of the property, to make it more marketable for the purpose of reselling it.
- Circumstances responsible for the sale of the property
- This generally includes circumstances that limit the property’s use for any reason other than resale.
- Motive and Intent
- This includes the taxpayer’s motives and intentions at the time the property was acquired, held in possession and sold. For instance, a taxpayer conducting business in real estate transactions for the purpose of profit will likely maintain the motive and intent of reselling the property at the earliest opportunity possible.
It should be clear by now that the elements in Happy Valley Farms Ltd. v. Minister of National Revenue are similar to the CRA factors listed above. However, their distinctions are significant, specifically in the context of property flipping. The “frequency or number of similar transactions” under the Happy Valley Farms Ltd. test appears to draw attention to the transaction carried out by individuals who are familiar and or associated with the real estate industry including for example real estate agents. Under the Happy Valley Farms Ltd. v. Minister of National Revenue elements the court appears to focus on the “frequency or number of similar transactions” creating the presumption that may (or may not) arise that a dealing in respect of the property has been (or is being) carried out in a business context.
The tax consequences of property flipping and assignment sale transactions are significant for tax purposes. Income from property flipping and assignment sales is business income that must be reported to the CRA and is fully taxable in the hands of the taxpayer. Property flipping and assignment sales, may also be subject to HST and or GST which create obligations for the taxpayer with respect to reporting his or her business income to the CRA.
Property flipping and assignment sales transactions do not benefit from the principle residence exemption in Canada’s tax act paragraph 40(2)(b) or paragraph 20(2)(c) where the land in question is used, by the taxpayer, in a “farming business” and it includes his or her principal residence.
Failure to correctly report profits from real estate flipping can also result in gross negligence penalties and potentially tax evasion charges. Advice from our Certified Specialist in Taxation Law Canadian tax lawyer is essential in these circumstances.
It should be clear by now that the elements in Happy Valley Farms Ltd. v. Minister of National Revenue are similar to the CRA factors listed above. However, their distinctions are significant, specifically in the context of property flipping. The “frequency or number of similar transactions” under the Happy Valley Farms Ltd. test appears to draw attention to the transaction carried out by individuals who are familiar and or associated with the real estate industry including for example real estate agents. Under the Happy Valley Farms Ltd. v. Minister of National Revenue elements the court appears to focus on the “frequency or number of similar transactions” creating the presumption that may (or may not) arise that a dealing in respect of the property has been (or is being) carried out in a business context.
The Consequences of Finding a Business an “Adventure or Concern in the Nature of Trade.”
Once it is determined that the transaction in question falls under the definition of business in the Income Tax Act the taxpayer must include all income (from the sale of the property) when he or she calculates its income for tax purposes. As previously mentioned, income (or profit) from a business is fully taxed as business income in the hands of the taxpayer. This inclusion of all business income contrasts with capital gains, wherein only 50% of the income recognized from the sale of capital property is taxed.
On the one hand, taxpayers with business income may benefit from anticipated gains. On the other hand, such taxpayer may (or not may) suffer from unanticipated business losses which would result in the ability to claim non-capital losses which can be carried back three years or forward.
Failure to report business income to the CRA may result in the taxpayer paying up to 10% penalty on his or her first omission. However, this penalty is likely to increase on subsequent omissions. Different penalties may also result if the taxpayer knowingly makes (or participates in making) false statements or omissions regarding business income to the CRA. This second type of penalty, the gross-negligence penalty, results in an additional 50% penalty on the taxes reassessed.
Tax Tips – “Adventure in the nature of trade”
All business income should be reported to the CRA. Taxpayers should familiarize themselves with the statutory limitation periods associated with reporting business income. Corporate tax returns must be filed within 6 months of their year-end. Individuals with business income (including spouse or common-law partner) have until June 15th of the following year to file their income tax. Individuals with business income should note that interest will accrue on tax unpaid after April 30.
If you have questions regarding a specific transaction and whether (or not) it constitutes a business transaction that is an “adventure in the nature of trade” or for inquiries regarding unreported business income, please contact our office to speaking with one of our experienced Canadian tax lawyers.
Disclaimer:
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."
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