The temptation to have profits on securities transactions taxed as capital gains, rather than as business income (which is 100% taxable), is too great for some taxpayers to resist—even if they are clearly running a securities trading business.
Take this recent tax case involving Tony Wong (Wong v The Queen, 2013 TCC 130), which was decided in late April 2013. Wong was reassessed for the 2003 through 2008 taxation years, and the only issue in question was whether his gains and losses from selling securities were on account of income or capital.
Wong is a licensed real estate and insurance broker in Ontario who has traded securities since 1988. He completed levels I and II of the Canadian Securities Program and previously held a mutual funds license.
When he filed his income tax returns for the years in question he failed to report any of his capital gains. Then, in July 2008, he made a request under the Voluntary Disclosures Program (VDP) to include various unreported capital gains from the sale of his securities in each of his 2003 to 2007 tax returns.
His VDP request was denied by the Canada Revenue Agency.
Wong argued that from 1996 to 2000, he incurred a capital loss from the sale of his securities, which, as of the end of 2002, totaled nearly $62,000 of available loss carry forwards.
So he didn’t report a gain or loss from his sale of securities when he filed his returns in those years because he knew he had that capital loss carried forward from prior years and he believed he had no taxes payable.
Wong’s position was that since CRA assessed his trading activity in those years on capital account, it was essentially precluded from considering his trading activity in the years now under review to be on his income account. He testified that his “investment style did not change from 1996 to the present and it is misleading for the CRA to reach different conclusions with respect to the same investor and the same investment account.”
Based on previous jurisprudence, the judge reviewed some of the factors that must be taken into account when determining whether a taxpayer’s gains from securities are on account of income or capital. Those factors are:
- the frequency of the transactions;
- the duration of the holdings;
- the intention to acquire the securities for resale at a profit;
- the nature and quantity of the securities; and
- the time spent on the activity.
But the judge emphasized that the critical factor in determining whether a taxpayer’s gains from securities are on account of income or capital is the intention of the taxpayer at the time he acquired the securities, which can be ascertained “from his entire course of conduct.”
To this end, the judge turned to Wong’s trading summaries for the five-year period under review, which showed he conducted more than 600 transactions.
The trades involved the purchase of more than 226,000 shares and the sale of more than 216,000 shares. The statements also showed Wong held most of the securities for a short period of time. Some were sold a few days after purchase, others the same day.
Wong said he was “not a professional investor”; invested in securities “by instinct”; “spent very little time on his activity with securities”; and “watched television to decide whether he would purchase or sell securities.” The judge found this to be “implausible” given the quantity of securities he traded and the duration of his holdings.
The judge concluded Wong’s profits on his sales of securities should be taxed as income. “[Wong] was engaged in trading in securities during the period[…]. This is a classic example of someone engaged in an adventure in the nature of trade,” he said.
The judge also said the fact that in prior years the CRA assessed Wong’s trading activity to be on his capital account doesn’t preclude the agency “from taking a different view of the matter in later years.”
ETFs and capital gains
While the structure of an ETF often makes taxes less concerning vis-à-vis a comparable mutual fund, ETFs can still trigger capital gains.
So Michael Nairne, CFP, CFA of Tacita Capital in Toronto, advises looking carefully at a fund’s underlying index composition to minimize taxes for clients.
“An ETF focused on a narrow band of securities that sees a great deal of turnover will frequently generate gains. This can lead to a year-end capital gains distribution,” he says. Conversely, a broad index has less turnover and, therefore, lower risk of distributions.
“The more affluent your clients, the more important it is that the advisor is doing a tax screen on potential investments,” he adds. Further, ETFs that employ covered calls trigger a stream of capital gains that are distributed by the fund. When a mutual fund makes a taxable distribution, there is corresponding reduction in Net Asset Value per Share (NAVPS). Hence, whether the distribution is by way of cash or reinvestment of additional units, it’s easy to track the Adjusted Cost Base (ACB) of the investment.
ETFs sometimes make taxable year-end notional distributions, which are neither cash distributions nor reflected in the reinvestment of additional units. So unitholders don’t see change in the number of units they hold, and the underlying NAVPS doesn’t change either. These notional distributions are reported by the custodial firm or dealer, but the ACB could be under-reported unless the custodial firm or dealer adds the notional distribution to the investment’s ACB.
Originally published in Advisor's Edge Report
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