Chief Justice Gerald J. Rip of the Tax Court of Canada invoked Ralph Waldo Emerson when summing up a case he decided last month (Leola Purdy, Sons Ltd. v The Queen, 2009 TCC 21) – “A foolish consistency is the hobgoblin of little minds.”
The dispute, which began as a classic question of income vs. capital gains treatment, became a lot more interesting when a secondary issue arose: whether you can carry forward a loss, which was not originally reported, from a tax year that is otherwise “statute-barred.”
The term “statute-barred” refers to a tax year that is literally barred from being reassessed by the Canada Revenue Agency. The general rule as set out in the Income Tax Act states the government has three years from the mailing date printed on your Notice of Assessment to come back and reassess you.
Before reviewing this secondary issue, let’s briefly review the facts of the case: Leola Purdy, Sons Ltd. (“Leola”) is a corporation 100% owned by John Purdy.
During its taxation years ending October 31, 1997 to October 31, 2002, Leola traded in various index futures contracts in the S&P 500 International Money Market Fund. The corporation always reported its gains and losses from its investments in those contracts on “capital account,” meaning only a portion of the gains (losses) were taxable. That portion declined from 75% from 1997 to 50% by 2002 when the capital gains inclusion rate was lowered in 2000.
During Leola’s 1998 tax year, the corporation reported various capital gains and losses from its trading activities, including a $6,000,000 capital loss from the trading of index futures contracts. The corporation’s 1998 tax return was assessed as filed on April 6, 1999 and became statute- barred on April 6, 2002.
During Leola’s 2002 tax year, the corporation also disposed of various index futures trading contracts and reported the net gain as a capital gain.
In 2005, the CRA reassessed Leola and found the $1.2 million capital gain in 2002 should have been reported as income since it constituted a business activity. As a result, instead of it being halftaxable, it became 100% taxable.
In court, the corporation conceded the 2002 futures contracts were properly taxable on income account. Leola argued if the gain on the sale of the contracts was on income account in 2002, then the loss on dispositions of the same contracts in 1998 must also be on income account, notwithstanding that Leola filed its 1998 tax return on the basis that the loss was a capital loss.
By doing so, Leola would be able to carry forward the unused amount and apply it against the reassessed income in 2002.
The CRA argued the only way to change the capital loss from 1998 into a non-capital loss that would then be available for carry forward to 2002 was to reassess the 1998 tax year. Since that year was statutebarred, it was unable to change the nature of the reported loss.
While the judge agreed that “1998 is a lost cause” since it had already been assessed and the assessment was now statute-barred, an error made in correctly assessing the true nature of Leola’s trading activity in 1998 had an impact on the corporation’s 2002 taxation year.
Allowing the non-capital loss carry forward, the judge wrote, “Nobody is saying that a statutebarred year can be reassessed. The tax the taxpayer has been assessed for the statute-barred year cannot be changed. But it’s valid and binding only for the year assessed. If an error was made in the assessment of the statute-barred year, which affects another year, the (CRA) in assessing the other year, must follow the Act and if there was an error in law in a previous year, including a statute-barred year, that error ought to be corrected.”
Jamie Golombek, CA, CPA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Private Wealth Management in Toronto.