As the year-end approaches, we wish to point out some rules to consider in order to optimize your tax return.
In order for a capital gain or loss to be included in your tax return for 2014, you must execute your trades by December 24th at 1pm for securities listed on Canadian exchanges or by December 26th at 4pm for those listed on US Exchanges.
According to the Canada Revenue Agency, an investor disposes of their shares on the settlement date. This date is usually three business days after the order is executed.
As Canadian markets will be closed on December 25 and 26, a trade that is executed on December 24 will settle on December 31. Since US markets are open on December 26, trades executed on that date will also settle on December 31.
Are Losses Superficial?
It may be appropriate to trade in order to trigger losses on certain securities. However, one should be aware of rules regarding superficial losses.
What is a superficial loss? The law states that a loss is superficial if you have dispose of a security and, within 30 days before or after the disposition, you or a person affiliated with you acquires the same or identical property ("substituted property"). Therefore, transactions over a period of 61 days should be examined to determine if there is a superficial loss.
In addition, a superficial loss occurs if you or a person affiliated with you owns or has a right to buy (through an option), the substituted property 30 days after the sale.
For the purposes of the tax law, affiliates include:
- Your spouse;
- A company you control;
- Your RRSP, RRIF, TFSA and those of your spouse.
It should be noted that a child and his parents are not affiliated.
Other entities may be affiliated with you if more complex structures are involved. The analysis of this rule is beyond the scope of this article. It is recommended that you consult a tax professional for this issue.
In order for superficial loss rules to apply, an identical property must be acquired. How is "identical property" defined? To determine if a particular product is identical to another, the Canada Revenue Agency considers the legal structure of the issuer, the composition of assets, risk factors, investors' rights and restrictions associated with the asset. For example, the CRA believes that ownership of a TSE 300 fund will not necessarily be identical to that of a TSE 60 fund. Thus, a financial instrument will be identical to another if the investor does not have a preference to buy one instrument over another. Regarding stocks, the CRA believes that they are not identical properties if they are of different categories and include different interest, fees and privileges.
Therefore, if you sell securities and your RRSP, RRIF or a person affiliated with you acquires a replacement, you will lose the right to include the loss in your tax return.
What happens to the capital loss that is denied? It will be added to the cost base of the replacement property. If you or an affiliated person acquires the replacement property, your capital loss will be denied and the cost base of the securities acquired by the affiliated person will be increased. Thus, the tax loss will be deferred until the disposition of the replacement property.
The superficial loss rules may have unexpected results in some cases. Consider the example of an investor who acquires 200 shares of a company on November 26. If he decides to sell 50 shares on December 4 because the stock does not perform as expected, a superficial loss may apply to the entire loss. In fact, since the shares were acquired less than 30 days before the disposition on December 4, the superficial loss rules apply if the securities are still held on January 3rd.
If this person had instead disposed of all 200 shares on December 4 and reacquired five shares on December 23, a superficial loss would eliminate the capital loss. However, unlike the previous example, the loss denied would equal 5/200 of the capital loss, as only five shares will have been acquired. Finally, this person must have the five shares on hand on January 22 for a superficial loss to be incurred.
It should be noted that day traders are not subject to the superficial loss rules as these target only losses of a "capital" nature.
Finally, there is no equivalent rule for transactions that generate a capital gain. Thus, all transactions that result in a gain must appear on your tax return.
Previously, we mentioned that a superficial loss realized by an investor would add to the securities acquired by the person affiliated with him. In some circumstances, this rule can produce interesting results as it allows the transfer of losses between spouses, which is usually not allowed.
Consider the case of a couple where the husband has a significant unrealized capital loss and the wife; a substantial capital gain for the year. To allow the transfer of capital loss to the wife, the following transactions can be carried out:
- The husband sells his securities at a loss;
- Within 30 days of the disposition, the wife buys the same securities on the market;
This transaction will qualify for the superficial loss rules and the cost of the shares acquired will be increased by the amount of capital loss of the husband.
- At the end of the 30 day period, the wife may dispose of the securities and declare a capital loss.
You will have noted that it may be difficult to determine which transactions are subject to the superficial loss rules for someone who makes many transactions or partial dispositions. In all cases, investors should keep these rules in mind when preparing their tax return.
We wish you happy holidays and good returns over the next year!
Since the levels and bases of taxation can change, any reference in this publication to the impact of taxation should not be construed as offering tax advice; as with any transaction having potential tax implications, clients should consult with their own tax advisors.