In response to recent market volatility, some investors are considering tax-loss selling to offset tax on capital gains realized in the year, or to recover tax paid on capital gains realized in the three preceding years. When considering these strategies, clients should heed two rules: the superficial loss rule, and the denied loss rule that applies when property is transferred directly to a registered plan.
Consider the following example:
Earlier this year, Anita realized capital gains on the sale of publicly traded securities. To minimize taxes, she has decided to transfer in-kind a portion of her non-registered mutual funds (specifically, ABC fund) to her RRSP. Anita believes doing so will allow her to achieve two goals:
- get an early start on her RRSP contribution for the year; and
- offset capital gains from the sale of her securities earlier in the year (recent market volatility has depreciated the value of ABC fund).
Anita’s objectives are not the problem; the issue is with the manner in which she proposes to meet them. Under the Income Tax Act, there are two rules that would frustrate Anita’s ability to claim a capital loss triggered on an in-kind transfer of securities or mutual funds directly to her RRSP. The first is a superficial loss rule; the second is a separate denied loss rule.
A superficial loss is a taxpayer’s loss on the disposition of a property where, during the period that begins 30 days before the disposition and ends 30 days after the disposition, the taxpayer or a person affiliated with the taxpayer acquires identical property.
Under the ITA, affiliated persons include:
- a spouse or common-law partner;
- a corporation and a person by whom the corporation’s controlled;
- two corporations if controlled by affiliated persons;
- certain corporate and partnership relationships; and
- certain trusts (since March 2004).
The inclusion of person-trust relationships impacts trusteed RRSPs, RRIFs, TFSAs and RESPs. For purposes of the superficial loss rule, these registered plans are now affiliated with their annuitant, holder or subscriber. So, the superficial loss rule applies where property is transferred from the annuitant, holder or subscriber to these plans and the plan retains ownership of the property – or identical property – beyond the superficial loss period. Where the superficial loss rule applies, the taxpayer’s capital loss is denied. (In the case of individuals, the loss is added to the ACB of the affiliated person. Where the affiliated person is not a registered plan, the loss is available for future use on the sale of the property by the affiliated person.)
The second rule that would frustrate Anita’s objectives, the denied loss rule, has a similar result. Capital losses are denied where property is transferred directly to certain trusteed registered plans, including deferred profit sharing plans (DPSPs), employee profit sharing plans (EPSPs), RDSPs, RRSPs, RRIFs and TFSAs. Presumably, the rule’s purpose is to ensure capital losses are available only when capital property is truly disposed of.
To achieve her objectives while avoiding the superficial and denied loss rules, Anita should consider triggering her capital loss outside her RRSP. If her aim is to reacquire her original mutual funds within her RRSP, she can wait 30 days to clear the superficial loss period before reacquiring the same funds. She would also want to be sure her RRSP (or any of her affiliated accounts) did not purchase or hold identical property in the 30-day period leading up to the sale of ABC fund. Here are two options:
- Anita can dispose of ABC fund by switching to cash or a different security; say, DEF mutual fund. This would occur outside the RRSP.
- Anita can then immediately contribute the cash or DEF fund in-kind to her RRSP.
- To clear the superficial loss period, 31 days after the sale of ABC fund, Anita’s RRSP can reacquire ABC fund.
- Anita can dispose of ABC fund by switching to cash or a different security; say, DEF mutual fund. This would occur outside of the RRSP.
- To clear the superficial loss period, Anita can wait 31 days after the sale of ABC fund to reacquire ABC fund.
- Anita can then transfer ABC fund in-kind to her RRSP.
These options avoid both the superficial and denied loss rules. The main difference between the two options is the timing of the RRSP contribution. In both cases, for Anita to be able to use the capital loss triggered on sale of ABC fund, a 60 day period must pass – 30 days before the loss is triggered and 30 days after – before her RRSP can acquire the fund. Where both the superficial and denied loss rules are avoided, Anita’s objectives of triggering a useable capital loss while also contributing to an RRSP can be met.