The phrase “tax audit” ranks with “root canal” and “blind date” to cause panic and stress. Investors who dabble in options contracts need to be aware of certain triggers that could lead CRA to take a closer look at your taxes.
According to James Rhodes, a former Department of Justice lawyer who specializes in taxation, options trades often fall into a “neutral zone” between what is clearly income and what is clearly a capital gain.
When is a capital gain not a capital gain?
Options, rights and warrants must be reported on a T5008 on an investor’s income tax form. Stock dividends are reported on a T5. Options that expire do not have to be reported on a T5008. The proceeds are taxed as capital gains, losses or dividends.
However, under certain circumstances the funds could be considered income instead of a capital gain, and taxed at the investor’s marginal tax rate. For example, stockbrokers who make trades on their own accounts will likely have the investment gains taxed as income rather than a capital gain because they have unique expertise and knowledge in the area.
The CRA considers the following factors:
Frequency: a history of extensive buying and selling of securities, or a quick turnover of properties
Period of ownership: securities are owned for a short period of time
Knowledge of securities: “the taxpayer has some knowledge of or experience in the securities markets” and securities transactions form part of the taxpayer’s ordinary business
Time spent: a substantial part of the taxpayer’s time is spent studying the securities markets and investigating potential purchases
Financing: security purchases are financed primarily on margin or by some other form of debt
Shares: the type of shares purchased are normally speculative and non-dividend paying in nature
CRA considers the combination of factors above to determine whether a taxpayer is engaged in the business of buying and selling options, or is a speculative investor. If CRA determines the taxpayer is in business (“an adventure or concern in the nature of trade”) any gains or losses are taxed as income at the marginal tax rate. The gain or loss on short sales are also taxed as income, and “the presumption that gains from security transactions are on income account will also be taken in any situation where it is apparent the taxpayer has used special information not available to the public to make a quick profit.”
A taxpayer can apply for a capital gains exemption under section 39 of the Income Tax Act, but a share option contract does not qualify for that exemption. So investors need to understand all the tax implications before they enter into options contracts.
Securities companies must complete a T5008 for each transaction completed, and this form is filed with CRA. It shows an investor’s name and SIN. When claiming capital gains, investors are required to fill out a Schedule 3 with their tax return. Rhodes states “CRA is going to look at the size of the capital gain claimed and the frequency of trade as reported on the T5008. If the investor has a great deal of activity, it could be a red flag for further investigation.” Other flags include:
Sporadic low income and high capital gains. Most people who day trade do not have full-time jobs, because day trading requires a great deal of time and attention to research and follow the market. Rhodes says, “CRA could wonder how the investor is financing the trades on the declared income and investigate further.”
Frequent trades. When the T5008 and the Schedule 3 are compared, frequent trading patterns, or short selling may trigger an investigation. Most investors still maintain a buy and hold philosophy when it comes to stock ownership.
Unique expertise and knowledge of the industry. A person in the business of stock trading has unique knowledge and expertise that others do not have. A real estate broker who buys and sells a condo in a short period of time could also have the capital gain taxed as income under the same criteria, even if it was the place of residence for a period of time.
Previous discrepancies or audits. If your return has been flagged in the past, your chances of another audit increase.
When a return is flagged for investigation, CRA follows verification and enforcement procedures.” Rhodes states CRA will request further information to clarify the deduction claimed. “The most common error people make when completing the Schedule 3 is to lump all the transactions together rather than itemizing it. If the Schedule 3 doesn’t line up with the T5008, it could be investigated further.”
For more information, go to IT479R: “Transactions in Securities,” Canada Revenue Agency.