Since capital gains are only half taxed, the distinction between capital gains and income is very important.
Capital property is property on which any gain is taxed as a capital gain. Only half of a capital gain is included in income in your tax return — the “taxable capital gain”. Thus, the effect is that capital gains are taxed at half the rate of ordinary income such as interest or employment income.
Not all gains are capital gains. If you are in the business of buying and selling goods — for example, operating a retail store — then obviously your gains from the goods you sell are business profits, which are fully taxable, and not capital gains.
Some types of gains fall close to the line. The Income Tax Act defines the term “business” — the income from which is fully taxable — as including an “adventure in the nature of trade”. This phrase has been interpreted in hundreds of reported court cases.
If what you are doing is a “business” or an “adventure in the nature of trade”, then your gain will be fully taxable as the sale of inventory. If it is not, then your gain will be only half taxed as a capital gain. On the flip side, business losses are fully deductible from income, while capital losses are only half-deductible, and normally only against taxable capital gains.
So how do you determine the difference between capital property and inventory?
Basically it comes down to intention. If you buy a property with the intention of selling it, then you are considered to be in business and the gain will be fully taxed as business profit.
The most difficult issues usually arise with respect to real estate. You might build a home to live in (capital), but also with plans to sell it (inventory). Your company might buy land on which to develop a shopping plaza to lease out (capital), or on which to develop a subdivision of new homes that you will sell (inventory).
The Canada Revenue Agency’s Interpretation Bulletin IT-218R, “Profit, Capital Gains and Losses from the Sale of Real Estate”, provides the Agency’s views on whether the purchase and sale of real estate will be treated as leading to business profits or capital gains. Paragraph 3 of the Bulletin sets out twelve factors that the CRA considers relevant:
(a) the taxpayer’s intention with respect to the real estate at the time of its purchase;
(b) feasibility of the taxpayer’s intention;
(c) geographical location and zoned use of the real estate acquired;
(d) extent to which the intention was carried out by the taxpayer;
(e) evidence that the taxpayer’s intention changed after purchase of the real estate;
(f) the nature of the business, profession, calling or trade of the taxpayer and associates;
(g) the extent to which borrowed money was used to finance the real estate acquisition and the terms of the financing, if any, arranged;
(h) the length of time throughout which the real estate was held by the taxpayer;
(i) the existence of persons other than the taxpayer who share interests in the real estate;
(j) the nature of the occupation of the other persons referred to in (i) above as well as their stated intentions and courses of conduct;
(k) factors which motivated the sale of the real estate;
(l) evidence that the taxpayer and/or associates had dealt extensively in real estate.
In determining your intention with respect to the property, the Courts have also developed the concept of a “secondary intention”. If you have an intention of using the property as capital property, but a secondary intention of selling it if the main intention does not pan out, then the property may be considered to be inventory and the gain fully taxable. The CRA’s Interpretation Bulletin IT-459 discusses this issue. Of course, just about everyone will sell their property if the right offer comes along, so the secondary intention has to be something more than just a willingness to sell if the price is right. There is often no clear dividing line, but the Federal Court of Appeal said in the 2008 Canada Safeway case that for there to be a secondary intention, it “must have been an operating motivation in the acquisition of the property”.
The prospect of treating your principal residence (your home) as capital property is always attractive. Even better than the regular “half tax” treatment given to capital gains, the gain on a principal residence is normally completely exempt from tax.
However, if you are in the construction business, or if you change homes often, watch out! Many small home builders have tried building a home, moving in, then selling it and moving on to another home, repeating the process a few times. If you do this, the CRA will determine that you do not have an exempt capital gain after all. Instead, you are treating each home as “inventory” — even though you lived in it — and you will be fully taxed on the gain as business profit. And if you haven’t kept all of your receipts for the costs of construction, you might have a hard time proving that your profit was less than the CRA claims it was!
(To make matters worse, if this happens you will also be required to pay GST or HST on the entire value of the new home, including the land, as of the date you moved in. As well, unless you have kept receipts showing GST/HST paid on construction costs, your offsetting input tax credits will likely be denied. Quite a number of small home builders have taken such assessments to the Tax Court of Canada and have lost, on both the GST and the principal residence issues.)
Note that real estate transfer records are permanent and easily available to CRA auditors once they start looking, and in many cases there will be no statute of limitations — e.g. because your return had a misrepresentation attributable to “carelessness or neglect”, or you didn’t file a GST return.
The CRA has been known to go after builders even 10, 15 or 20 years after the fact and assess them for tax, GST or HST, penalties and vast amounts of interest that has accrued over the years. If you are in this situation, consider making a Voluntary Disclosure before the CRA comes calling.
Note also that if you sell residential property after owning it for less than 365 days, then under new rules that took effect January 2023, the property is deemed to be inventory and not capital, unless you can show that the sale was due to one of various listed events, such as marriage, divorce, having a baby or being fired from a job. (This rule doesn’t change the law very much, as CRA auditors would generally consider such a quick sale to be inventory anyway.)
When it comes to shares of corporations and other securities, such as bonds and mutual fund units, the CRA generally accepts that most people hold such securities as capital property, even where the shares are junior stocks that are unlikely to pay a dividend any time soon. However, if you trade very actively, buying and selling shares on a regular basis and holding them for only short periods, you might be found to be in business, so that your gains would be fully taxed. (If you have losses, this will be to your advantage.)
You can avoid this situation, with respect to shares in Canadian companies, by filing a “Canadian securities election” (subsection 39(4) of the Income Tax Act), on Form T123, with your tax return. Once you make this election, all Canadian securities you hold are deemed to be capital property, forever. (In other words, if you have losses from very active trading in a later year, those losses will be capital losses that have limited use, rather than business losses that you can deduct against other income.)
Note that the Canadian securities election does not apply to all Canadian shares. There is an exclusion for “prescribed shares”, listed in section 6200 of the Income Tax Regulations. These include:
- private corporation shares whose value is primarily attributable to real property or resource property
- debt to a person or corporation with whom you do not (or did not) deal at arm’s length
- shares or debt acquired from a person with whom you did not deal at arm’s length (this would include shares you inherited from a deceased family member)
- exploration and development shares
- shares or debt substituted for any of the above.
The election is also not available to a “trader or dealer” in securities.
Lots of rules to be careful about!