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Capital-Gains Tax Planning: Capital-Gains Reserve for Future Amounts Receivable under Subsection 40(1) of Canada’s Income Tax Act – A Canadian Tax Lawyer’s Analysis

Introduction – Taxation of Capital Gains in Canada & Capital-Gains Reserve for Future Proceeds: Subsection 40(1) of the Income Tax Act

Generally, when a taxpayer disposes of a capital property—e.g., real property, corporate shares, a partnership interest, mutual funds, etc.—and realizes a capital gain, the taxpayer must include one-half of the gain in his or her income. In other words, only half of a capital gain is taxable. The rules for determining whether a disposition gives rise to a capital gain or regular income are complex and are not discussed here.

If, on the other hand, the taxpayer sells the property at a loss, the taxpayer may deduct one-half of the loss from the taxable portion of any capital gain. So, only half of a capital loss is an allowable deduction, and the deduction may only be used to offset taxable capital gains. That is, allowable capital losses generally cannot be used to offset, say, business income or employment income. (There are exceptions, however. For instance, if a deceased taxpayer has allowable capital losses remaining after applying all available carryovers, the excess losses may offset any source of income on the deceased’s income-tax return for the year of death or for the year before the year of death. Another example: an allowable-business-investment loss (ABIL) is a specific defined type of capital loss that may be deducted from any source of income.)

Two amounts are used to compute the amount of a capital gain or loss. The first is the adjusted cost base (ACB), which is the taxpayer’s tax cost for acquiring a capital property. The second figure is the taxpayer’s proceeds for disposing of the capital property. The ACB, when deducted from the proceeds of disposition, determines the amount of a capital gain or loss when a taxpayer disposes of a capital property. For example, a taxpayer buys a rental property for $100,000 and sells it a few years later for $150,000. In this case, the taxpayer’s adjusted cost base is $100,000 and the proceeds are $150,000. The taxpayer therefore realizes a capital gain of 150,000 – 100,000 = $50,000. The taxpayer must report one-half of the gain—i.e., $25,000—as income. Say instead that the taxpayer sold the property for $75,000. The taxpayer will then realize a capital loss of 75,000 – 100,000 = $25,000. The taxpayer may deduct one-half of the loss—i.e., $12,500—from any other realized capital gain and can carry those losses back three years or forward indefinitely to deduct against capital gains incurred in those years.

If you sell a capital property, you must generally report the capital gain on your tax return for the year of sale even if you don’t receive full payment that year. This is because a taxpayer who sells a capital property must report the resulting capital gain in the taxation year that “the property was disposed.” In other words, the capital-gains tax is triggered not by the receipt of sale proceeds but by the “disposition.”

But subsection 40(1) of the Income Tax Act allows a qualifying taxpayer to defer a portion of the capital-gains tax by claiming a reserve when the taxpayer doesn’t receive full payment in the year of disposition.

This article examines the capital-gains reserve rules.

Who Qualifies for the Capital-Gains Reserve?

Generally, any taxpayer who disposes of a Canadian capital property may claim the capital-gains reserve unless the taxpayer falls into any one of the following categories:

  • the taxpayer was not a tax resident in Canada at the end of the tax year in which the disposition occurred;
  • the taxpayer was not a tax resident in Canada at any time during the tax year immediately following year in which the disposition occurred;
  • the taxpayer was exempt from paying Canadian income tax at the end of the tax year in which the disposition occurred;
  • the taxpayer was exempt from paying Canadian income tax at any time during the tax year immediately following the year in which the disposition occurred; or
  • the taxpayer sold the capital property to a corporation that the taxpayer controlled in any way.

And of course, the reserve is unavailable entirely if the taxpayer receives full payment in the year of sale.

How Is the Capital-Gains Reserve Calculated?

The capital-gains reserve offsets the amount of the capital gain that you’d otherwise need to report. In other words, you start by computing the capital gain (i.e., the gain before deducting the reserve), and you then deduct the amount of the available reserve that you wish to claim. Notably, the reserve doesn’t eliminate the capital gain entirely; it simply defers a portion of the capital gain two subsequent years. So, if a reserve is claimed in a particular year, the amount of that reserve must be reported as a capital gain on the following year’s income-tax return, and the following year’s gain may be reduced by any reserve available for that year. You may repeat this process until you’ve exhausted the available capital-gains reserve. Note: as explained below, the reserve is only available for five years in total.

Subsection 40(1) gives a formula for calculating the maximum reserve deduction available in any particular tax year. Specifically, the maximum reserve that a taxpayer may deduct is the lesser of two amounts:

  • the capital gain otherwise determined x the proceeds payable after the year / total proceeds payable
  • the capital gain otherwise determined x (4 – number of preceding tax years ending after the disposition date)

This formula basically limits the life of the capital-gains reserve to five years. The formula also means that, for those five years, the maximum amount reserve deductible is

  • 80% of the gain in the year of disposition;
  • 60% of the gain in the first year after the year of disposition;
  • 40% of the gain in the second year after the year of disposition;
  • 20% of the gain in the third year after the year of disposition; and
  • zero in the fourth year after the year of disposition.

In other words, if you sell a capital property but don’t receive any proceeds in the year of disposition, you must still recognize a minimum of 20% of the capital gain in each year starting with the year of disposition. And even if you won’t receive full payment until the tenth year following the sale, the capital-gains reserve formula is a tax trap that means that no reserve may be claimed for year five and beyond.

Example of Computing the Capital-Gains Reserve

In 2016, a taxpayer sells a capital property for proceeds of $1.4 million. The buyer pays 50% upfront and pays the remaining 50% in 2019. So, the taxpayer receives $700,000 in 2016 and the other $700,000 in 2019.
For simplicity, we’ll assume that the taxpayer’s adjusted cost base (ACB) was nil. So, the taxpayer’s capital gain would otherwise equal $1.4 million.
If the taxpayer sought to claim the maximum reserve deduction each year, here is how the calculation would look.

2016 (Year of Disposition)

In 2016, the taxpayer may claim a maximum reserve equal to the lesser of:

  • 1,400,000 x 700,000/1,400,000 = 700,000
  • 1,400,000 x 80% = 1,120,000

So, in 2016, the taxpayer reports a capital gain of 1,400,000 – 700,000 = $700,000.

2017

In 2017, the taxpayer must report a capital gain (before applying 2017 reserve deduction) in the amount of the reserve claimed in 2016. So, there’s a capital gain of $700,000.

In 2017, the taxpayer may claim a maximum reserve equal to the lesser of:

  • 1,400,000 x 700,000/1,400,000 = 700,000
  • 1,400,000 x 60% = 840,000

So, in 2017, the taxpayer reports a capital gain of 700,000 – 700,000 = nil.

2018

In 2018, the taxpayer must report a capital gain (before applying 2018 reserve deduction) in the amount of the reserve claimed in 2017. So, there’s a capital gain of $700,000.

In 2018, the taxpayer may claim a maximum reserve equal to the lesser of:

  • 1,400,000 x 700,000/1,400,000 = 700,000
  • 1,400,000 x 40% = 560,000

So, in 2018, the taxpayer reports a capital gain of 700,000 – 560,000 = $140,000.

2019

In 2019, the taxpayer must report a capital gain (before applying 2019 reserve deduction) in the amount of the reserve claimed in 2018. So, there’s a capital gain of $560,000.

In 2019, the taxpayer may claim a maximum reserve equal to the lesser of:

  • 1,400,000 x 0/1,400,000 = 0
  • 1,400,000 x 20% = 280,000

Because the taxpayer received the other 50% of the proceeds in 2019, no capital-gains reserve is available in that year. So, in 2019, the taxpayer must report a capital gain of $560,000.

But suppose that the remaining $700,000 wasn’t payable in 2019 but in 2025. In that case, in 2019, the taxpayer could claim a maximum reserve equal to the lesser of:

  • 1,400,000 x 700,000/1,400,000 = 700,000
  • 1,400,000 x 20% = 280,000

And the taxpayer’s gain for 2019 would be 560,000 – 280,000 = $280,000.

In 2020, before applying the 2020 reserve, the taxpayer would have a capital gain of $280,000. The max reserve available in 2020 would be 1,400,000 x 10% = $140,000, which would result in a 2020 capital gain of $140,000.

Finally, in 2021, the taxpayer would have no reserve left and must recognize a final capital gain of $140,000. So, even though the taxpayer wouldn’t receive the full sale proceeds until 2025, the taxpayer must recognize the full capital gain by the 2021 tax year—albeit on a tax-deferred basis.

Extended Capital-Gains Reserve for Fishing Property, Farming Property & Shares in a Qualifying Small Business Corporation (QSBC)

The capital-gains reserve is more lenient if you transfer certain qualifying capital property to a child, grandchild, or great-grandchild. Qualifying capital property includes family farm property, family fishing property, shares in a family-farm corporation, shares in a family-fishing corporation, an interest in a family-farm or family-fishing partnership, and shares in a qualifying small-business corporation (QSBC shares). In addition, the transferee must be a Canadian tax resident at the time of receiving the qualifying property. In these cases, the capital-gains reserve has a 9-year lifespan, and the maximum deductible ranges from 90% of the gain in the year of disposition to 10% of the gain in year nine.

Tax Tips: Tax Planning & The Capital-Gains Reserve

Subparagraph 40(1)(a)(iii) of the Income Tax Act expresses the capital-gains reserve as “such an amount as the taxpayer may claim.” This means that the capital-gains reserve is optional, not mandatory. You need not claim the capital-gains reserve, and, if you claim it, you need not claim the maximum allowable amount.

This flexibility opens up the possibility for some tax planning using the capital-gains reserve. Of course, in most circumstance, you’ll benefit from claiming the maximum capital-gains reserve allowed each year. The resulting tax deferral is especially beneficial if you expect to be in the same or a lower tax bracket over the four years following the anticipated sale. But special circumstances might make the capital-gains reserve undesirable—the availability of capital losses, for example. In addition, you should consider how the deferred capital gain might affect your entitlement to income-tested benefits in the recognition year. By deferring the capital gain to a year in which you become entitled to receive Old Age Security, you may see your entitlement reduced.

If you plan on selling a property with accrued capital gains, and you won’t receive the full purchase price upfront, the capital-gains reserve might allow you to defer capital-gains tax. For advice on tax-planning strategies using the capital-gains reserve, and to avoid the tax trap of receiving payments beyond the reserve period, consult one of our expert 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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