If you own capital property that has gone down in value, you’ll want to ensure that you can maximize the potential tax savings by using losses in particular ways. Depending on how you go about selling the property to realize a loss, there is a danger that these tax savings could disappear.
Income tax rules in Canada restrict how you can utilize capital losses if you don’t permanently dispose of the property. These are known as the “stop-loss” rules, and they operate to deny taxpayers the use of losses in certain circumstances. For individuals, the most important rules to be aware of are the “superficial loss” rules.
Superficial Loss Rules for Income Tax in Canada
The Canadian Income Tax Act (the “Tax Act”) contains provisions that are designed to prevent the selling and trading of losses between Canadian taxpayers. One of the ways the Tax Act does this is through the “superficial loss” rules. They state that a taxpayer’s loss from the disposition of capital property is deemed to be nil to the extent that they are superficial losses. Generally the superficial loss rules do not apply when a corporation disposes of property to another corporation. When a person does capital transactions with another person or a corporation the superficial loss rules may be triggered.
Simply speaking, a superficial loss is the loss from the disposition of property where:
- The same or identical property (also known as substituted property) is acquired by the individual or an “affiliated person” during a period beginning 30 days before the disposition and ending 30 days after the disposition;
- At the end of the period, the individual or the affiliated person owns or has a right to acquire the substituted property.
To clarify, when an individual disposes of a capital property and the same or substituted property is acquired by the individual or an “affiliated person” within the 61 day period, the loss will be considered superficial and deemed to be nil.
The purpose of these rules is to prevent taxpayers from artificially crystallizing a loss at a time of their own choosing and then reacquiring the property. For example, if a taxpayer knows that there are accrued losses in shares that they own, they may wish to realize the loss immediately but still maintain ownership of the shares. They could do this by either selling the shares, realizing the loss and then repurchasing shares, or by selling the shares to a spouse for fair market value and realizing the loss. The superficial loss rules prevent such aggressive tax planning.
In order to determine if the superficial loss rules are triggered, it is necessary to look to the definition of “affiliated person” under the the Tax Act.
Subsection 251.1(1) of the Tax Act defines “affiliated persons” as:
- An individual and a spouse or common-law partner;
- A corporation and the person by whom the corporation is controlled, including the spouse or common-law partner of the controlling individual;
- A partnership and the majority interest partner;
- A trust and the majority-interest beneficiary, including the spouse of the majority interest beneficiary.
The superficial loss rules therefore operate to prevent the realization of losses by a taxpayer by taking into account close relationships.
Exemptions from the Superficial Loss Rules
Although the criteria for superficial losses may be met, there are exceptions.
For example, a disposition will not result in a superficial loss if it is or deemed to be a disposition that arose as a result in a change of use of the property contemplated under the Tax Act which deals with change of use for certain types of property. So, for example, if a taxpayer decides to move out of their home and rent the vacated property, the superficial loss rules will not apply. Other sections of the Tax Act normally deem a disposition in these circumstances regardless of the fact that ownership may not have changed hands in the first place.
Other exemptions to the superficial loss regime are:
- In the case of deemed dispositions on the death of a taxpayer;
- A deemed disposition upon the taxpayer’s change of residence;
- The expiry of an option.
Given that the sharing of losses within a corporate group is normally acceptable under Canadian tax law, paragraph 40(3.3)(a) of the Tax Act serves to exempt most dispositions made by corporations.
Capital Losses are not “lost”
Although superficial losses deem the taxpayer’s loss to be nil at the time of disposition the loss does not completely disappear. When a taxpayer disposes of a capital property and then reacquires it within the 61 day period, or the property is acquired by an affiliated person, the amount of the superficial loss is then added to the adjusted cost base of the capital property in question. This means that the loss does not stay in the hands of the seller, but rather follows the property. The loss will be realized by the new owner of the capital property when they dispose of it at a later date by virtue of the adjustment to the property’s adjusted cost base. This creates some interesting and attractive planning opportunities.
Planning and the Superficial Loss Rules
As was already mentioned, the definition of “affiliated persons” is quite narrow, and problems most often arise when spouses attempt to trade losses between each other. Should a taxpayer wish to realize losses but still maintain economic ownership of capital property through family members, the property may be sold to a family member such as a child to avoid the superficial loss rules.
It would appear that the superficial loss rules actually enable the transfer of losses from one individual to an affiliated person providing certain steps are taken. For example, if the owner of the capital property transfers that property to his or her spouse, the transferor spouse will be able to utilize those losses to offset gains from other sources providing certain other steps are taken.
First, in order to ensure that the losses will not be attributed back, the spouses will want to make an election to have the transfer take place at fair market value and to actually take back proceeds equal to that amount. Secondly, the transferee spouse should wait until the 61-day period has expired before disposing of the shares and realizing the loss.
Though both of these strategies have been successful in the past, the income tax rules are changing. The CRA and Revenue Canada have been using the General Anti-Avoidance Rule found in the Tax Act to clamp down on over aggressive tax planning. Anyone attempting to share losses through the use of the superficial-loss rules would be well advised to seek professional advice from an experienced Canadian income tax lawyer.
From a single taxpayer perspective, the superficial loss rules can also be used to provide a “grace period” for realizing losses. For example, if at year end a taxpayer disposes of a capital property with an accrued loss, he or she will have 30 days within which to decide if they wish that loss to crystallize. If this is done at year end the taxpayer will have more time to investigate and determine which of the two tax years would be more beneficial to realize the loss.
The Sale of Shares to a Controlled Corporation
Many small business owners may be concerned that the sale of shares to a corporation they control may be affected by the superficial loss rules. Under the definition of “affiliated persons” an individual is affiliated with the corporation that he or she effectively controls.
Under such circumstances the superficial loss rules would apply. Therefore, because superficial losses effectively attach to the capital property the loss will not be capable of being realized by the transferor if the shares are retained by the corporation beyond the 61 day period. In such a case, when the corporation finally sells the shares, it will receive the benefit of any losses that may still be available.
In certain circumstances this could be an effective way to offset the income of the corporation, however the transferor will have no further access to them. Careful planning in this regard would be prudent.
Canadian Tax Lawyer Assistance
If you are concerned about the application of the superficial loss rules to a transaction you are about to undertake, get in touch with our Ontario tax lawyers. Effective planning is necessary to ensure that you do not lose the economic benefit of accrued losses in your capital property. Given the current uncertainty created by the General Anti-Avoidance Rule, expert legal income tax advice is a necessity.
"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."