335 CHAPTER 8 Capital Gains And Capital Losses Economic Background Capital Assets And Income Taxation Policy 8-1. The discussion of business income in Chapter 6 noted that capital gains and losses arise ‘on the disposition of assets that are earning business or property income. In general, the income from the sale of such assets will be incidental to the ongoing activities that produce business income and, as a consequence, a case can be made for exempting any resulting capital gains and losses from income taxation. 8-2. This case is reinforced during periods of high inflation. Ifa businessis going to continue operating as a going concern, it will usually have to replace any capital assets that are sold. As gains on the sale of capital assets often reflect nothing more than inflationary price increases, such gains cannot be distributed to the owners of the business as they must be used to finance the replacement of the assets sold. 8-3. Until 1972, Canadian tax legislation did not levy any income tax on capital gains. One of the most significant changes in the 1972 tax reform legislation was the introduction of taxa~ tion on capital gains as the government believed that the ability to completely escape taxation ‘on this type of income was creating severe inequities in the taxation system. 8-4. The capital gains taxation that became effective January 1, 1972, represented a compromise between the view that capital gains should be exempt from tax and the position that such freedom from taxation creates serious inequities among various classes of taxpayers. Taxation of capital gains was introduced, but on a basis that was very favourable to the taxpayer. Capital gains were considered a source of income that was not business or property income, even though capital gains and losses could be created by the disposition of assets that earned business or property income. 8-5. _In simple terms, the 1972 rules indicated that one-half of a capital gain would be treated as a taxable capital gain and, similarly, one-half of a capital loss would be deductible against capital gains as an allowable capital loss. This meant that for a taxpayer in the 45 percent tax bracket, the effective tax rate on capital gains was an attractive 22.5 percent. Lifetime Capital Gains Deduction 8-6. Even though capital gains taxation was applied in a very favourable manner, there was a continuing view that any taxation of such income was not appropriate. Asa reflection of this336 Chapter 8 General Rules view, in 1985, the government introduced the lifetime capital gains deduction. This legisla- tion provided that every Canadian resident could enjoy tax free treatment of up to $500,000 of capital gains on the disposition of any type of capital asset. From its introduction, this provi- sion was heavily criticized asa gift to higher income Canadians, particularly in view of the fact that it was available on any type of capital gain. It was difficult for many analysts to see the ‘economic justification for providing favourable tax treatment of gains on the sale of a wealthy Canadian’s Florida condominium 8-7. Asa result of such criticism, a variety of limitations were introduced over subsequent years. Without going through a detailed history, we would note that, under current legisla- tion, a $750,000 deduction is available on gains resulting from the disposition of shares of a qualified small business corporation, or the disposition of a qualified farm or fishing property. 8-8. It should be noted here that the provisions related to the lifetime capital gains deduc- tion do not affect any of the material in this Chapter. The lifetime capital gains le not alter the determination of the amount of taxable capital gains to be included in Net Income For Tax Purposes. Rather, the legislation provided for a deduction in the determina- tion of Taxable Income for all or part of the taxable capital gains included in Net Income For ‘Tax Purposes. This material is covered in Chapter 11, Taxable Income And Tax Payable For Individuals Revisited. Changes In The Inclusion Rate 8-9. For gains and losses on capital assets disposed of subsequent to October 17, 2000, the inclusion rate has been one-half. Asthe focus of this textis on the 2011 taxation year, the only relevance of alternative inclusion rates is for allowable loss carry forwards resulting from dispositions that occurred prior to October 18, 2000. As will be discussed in Chapter 11, allowable capital losses can be carried forward indefinitely. This means that if they are carried forward from dispositions prior to October 18, 2000 using an inclusion rate other than one-half, the inclusion rate will have to be adjusted. 8-10. Given this situation, we will give only limited attention to examples involving alterna- tive inclusion rates. For reference purposes in dealing with alternative inclusion rates when they occur, inclusion rates for the period 1972 to the present are as follows: Period Inclusion Rate 1972 Through 1987 72 1988 And 1989 2/3 1990 Through February 27, 2000 3/4 February 28, 2000 through October 17, 2000 23 October 18, 2000 To Present 2 General Rules Capital Gains In The Income Tax Act 8-11. The material in this Chapter is a continuation of our discussion of the calculation of Net Income For Tax Purposes. In Chapter 3, detailed attention was given to employment income. In terms of the Income Tax Act, this discussion was based on Subdivision a of Division B. Chapters 5, 6, and 7 dealt with Subdivision b of Division B and provided a comprehensive consideration of business and property income. This included detailed coverage of the calcu- lations related to capital cost allowance (CCA), an important deduction in the determination of both business and property income. 8-12. Capital gains and losses are the third major component of Net Income For Tax Purposes. This subject is covered in Subdivision c of Division B, Sections 38 through 55. Sections 38 and 39 define taxable capital gains, allowable capital losses, and other items that relate to the calculation of these amounts. Section 40 provides the general tax rules for computing these amounts. The remaining Sections 41 through 55 deal with more specificCapital Gains And Capital Losses General ules matters, such as identical properties (Section 47), adjustments to the cost base (Section 53), and various additional definitions (Section 54), Capital Gains Defined Capital Assets 8.13. In general, capital gains can occur when a taxpayer disposes of a capital asset. You will recall that capital assets were described in Chapter 6 as being those assets which are capable of earning income in the form of business profits, interest, dividends, royalties, or rents, Further, the assets must be held for this income producing purpose, rather than for a quick resale at a profit. 8-14. It was also noted in Chapter 6 that, in making the determination as to whether a particular amount of income was capital in nature, the courts would take into consideration the intent and course of the taxpayer's conduct, the number and frequency of transactions involving the type of asset under consideration, the nature of the asset, the relationship of the asset to the business of the taxpayer, and the objectives set out in the articles of incorporation. Capital Gains Election On Canadian Securities 8-15. Despite these guidelines, the fact that capital gains receive favourable income tax treatment has led to much controversy and litigation with respect to the distinction between capital and other assets. In the case of equity securities, itis often difficult to distinguish between those situations where a taxpayer is holding the securities in order to earn dividend income or, alternatively, holding the securities in order to generate a gain on their ultimate disposition. Fortunately, the Income Tax Act provides an election which keeps this issue out of the courts. 8-16. ITA 39(4) allows taxpayers, including corporations and trusts, to elect to have all Canadian securities that they own deemed to be capital property, and all sales of such securi- ties deemed to be dispositions of capital property. Once this election is made, it cannot be revoked and it applies to all future dispositions of Canadian securities by the taxpayer, thus assuring the taxpayer that all gains and losses will be treated as capital. 8-17. 1TA39(5) indicates that this election is not available to traders or dealers in securities, financial institutions, a corporation in the business of lending money or purchasing debt obli: gations, or non-residents. This election is obviously advantageous in the case of gains since only one-haltis taxable. However, inthe case of losses, this means only one-half is deductible and only against taxable capital gains. Dispositions Actual Dispositions 8-18. ITA 248(1) provides an extensive list of transactions that would be considered to be dispositions. The more important of these listed transactions are: + sales of property; + redemptions of debt securities or shares; + cancellations of debt securities or shares; + expirations of options; + expropriations of capital property; and + conversions of debt or shares. 8-19. _Ingeneral, transfers of capital assets are not considered to involve a disposition unless there is a change in beneficial ownership. For example, a transfer of property between two trusts with identical beneficiaries would not be considered a change in beneficial ownership and, asa result, the transfer would not be treated asa disposition. An exception to this general rule occurs when there is a transfer to an RRSP. Even though there is no change in beneficial ‘ownership, the transfer would be treated as a disposition of the transferred asset 337