Is your client a day trader?

Online investors who slip into day trading could face an unexpectedly large tax bill.

And without hard rules governing the type and frequency of trading activity that will trigger interest from the Canada Revenue Agency (CRA), it’s easy to run into trouble, said Toronto tax lawyer David Rotfleisch.

“Not everyone goes in thinking, ‘I’m going to start day trading,’” he said. “It can also be a circumstantial thing. You get interested, but you don’t trade a lot. All of a sudden, a few opportunities come up and you make a little money. You start trading a little more, and a little more and then bang, you’re offside.”

Determining the tax treatment of day trading in its purest form — multiple daily securities transactions aimed at profiting from short-term fluctuations in price — is a relatively straightforward matter, said Ray Loucks, director of tax with Crowe MacKay LLP in Vancouver.

Taxpayers running this kind of enterprise in non-registered accounts can expect to see their trading gains classified as business income, fully taxable at their marginal rate.  

At the other end of the spectrum, those using their online accounts to make the occasional trade of a long-held investment can be fairly confident that their profits will be considered capital gains, of which only 50% is taxed.

Things get more complicated for people whose trading patterns fall between those two extremes.

“There’s no bright line that says whether you’re a day trader or not,” Loucks said.

Instead, the CRA conducts a fact-specific assessment, looking at factors such as the frequency of the taxpayer’s transactions, how long they hold assets for, their intentions regarding their trades, their knowledge of the markets and time spent on the activity.

No single factor determines the trader’s status, but in general, shorter hold periods in combination with higher transaction volumes suggest the trading activity should be taxed as business income.

Still, it’s not all bad tax news for day traders taxed as businesses, said Kelly Leung, director of global tax with Docebo and a CPA in Toronto. She explained that the trading losses of taxpayers in this situation are fully deductible against income. In addition, day traders will be able to deduct legitimate expenses related to their business, including home office costs.

While varying how trading transactions are reported to the CRA in different tax years is possible, Leung said taxpayers should avoid doing so if they wish to reduce their chances of an audit.

“The CRA doesn’t like it when you switch back and forth,” she said, especially when the changes seem to correlate with a reduced tax burden, such as a taxpayer claiming capital gains treatment in a year when they made a trading profit, only to characterize their transactions as business losses in poorer performing years.

“That will be a red flag,” Leung added.

Frequent traders may be able to remove some uncertainty from their tax situation by making an election under s. 39(4) of the Income Tax Act. The election, which applies to Canadian securities only, allows them to have all their trades treated as capital transactions.

However, the election is permanent.

“It’s all-or-nothing,” Loucks said. “The downside is that if you do incur losses, those losses are only deductible against capital gains, whereas if they were treated on account of income, they would be fully deductible.”

No such election is available for cryptocurrency traders, but Rotflesich said that the CRA uses a similar set of criteria for determining whether crypto transactions are considered on account of business income or capital gains, considering the frequency of transactions, period of ownership and a taxpayer’s knowledge of crypto assets.

The relative youth of the crypto market and the lack of case law dealing with the issue make cryptocurrency taxation a particularly tricky area to navigate, Rotfleisch said, adding that his firm takes a granular approach to clients’ trading.

“We analyze each and every transaction and provide a detailed memo that supports their position,” he said.

Even if the CRA mounts a challenge, Rotfleisch said a comprehensive legal opinion could mitigate against the possibility of negligence penalties being imposed on top of a reassessed tax bill.

Rotfleisch said people who are serious about day trading should consider incorporating their business and paying themselves a salary in order to benefit from lower corporate tax rates and optimize their overall level of taxation.