TIPS AND TRAPS OF CAPITAL LOSS PLANNING
The COVID-19 pandemic has resulted in an economic downturn, volatile markets, and financial challenges for many businesses. Year-end tax planning is always valued, but perhaps this year more than ever. Let’s examine various considerations around capital loss planning from a
tax perspective, including the general rules and issues around superficial losses, and discuss the impact of capital losses on the capital dividend account (CDA).
Capital Losses – General Rules
The Canadian Income Tax Act (ITA) requires capital losses to be first applied against capital gains realized in the current year. If any remaining balances exist, the net capital losses can be used to either reduce taxable capital gains in any of the three preceding years, or in any other future year. Capital losses can only be applied against capital gains and cannot be offset
against any other type of income, such as business income or interest income.
With respect to capital losses that cannot be utilized in the current year, the best approach is to carry the losses back to the earliest year in the three-year window where the taxpayer has capital gains. For example, 2017 is the earliest year to which you are allowed to carry back losses in 2020.
Capital Losses and Superficial Loss Considerations
A superficial loss is a subset of capital losses that cannot be used to offset capital gains for tax purposes. Instead, the loss is added to the adjusted cost base (ACB) of the identical property.
For a capital loss to be deemed superficial, two conditions must be met:
- You or an affiliated person acquire the same or an identical property within 30 calendar days before or after the settlement date of the sale
(61 days total).
- You or an affiliated person still own the same or an identical property 30 calendar days after the settlement date of the sale. Affiliated persons can fall into one of four categories for the purposes of the ITA:
- Individuals, including yourself or your spouse.
- Corporations controlled by you or your spouse.
- Partnerships controlled by you or your spouse.
- Trusts where you or your spouse are a majority interest beneficiary (i.e., your RRSP, RRIF and TFSA. This also applies to an RESP where you or your spouse is a subscriber).
“Identical properties” are the same in all material respects, so a prospective buyer would not prefer one over another. To determine whether properties are identical, it is necessary to compare the inherent
qualities or elements that give each property its identity.
Strategies for Superficial Losses
There are a few ways to successfully realize capital losses and avoid the superficial loss rules. All the below strategies assume the sale of an investment.
- Assuming it’s not a partial disposition, wait at least 31 days from that settlement date before repurchasing the same investment or an identical
- Avoid repurchasing an identical property sold in your non-registered account within your registered (RRSP, RRIF, TFSA, etc.) account during
the superficial loss period. In-kind contributions to registered accounts of non-registered investments with unrealized losses will also result in such losses being denied.
- If selling a mutual fund trust, consider purchasing the same fund structured as a mutual fund corporation (or vice versa). These would not
be considered identical properties because the legal structure of each (trust vs. corporation) is different, providing different rights to each investor.
- Consider gifting investments with unrealized losses to an adult child, parent, or sibling. These losses would not be deemed superficial because the recipients are not affiliated persons.
- Consider planning for superficial losses with a spouse. If you don’t have capital gains this year or the previous three years, but your spouse does, it is possible to transfer capital losses to them. First, the investment
is sold to crystallize the capital loss. Immediately afterwards your spouse buys the exact same amount of the identical investment. Your spouse then sells the investment after waiting at least 31 days. The capital loss realized on your sale will be denied under the superficial loss rules and instead added to your spouse’s adjusted cost base, thereby transferring the capital loss.
Exceptions apply for superficial losses, including the following situations:
- Becoming a non-resident of Canada that results in the deemed disposition of assets.
- The property is deemed sold as the result of a change of use.
- There is a deemed disposition because of the death of the investment’s owner.
- You sell the investment but become income tax-exempt within 30 calendar days of the disposition.
Typically, the discussion on superficial losses reaches its peak near the close of each calendar year as investors sell investments with losses in the hopes of using them to reduce capital gains realized earlier in
the year. Remember that investment objectives and long-term goals trump short-term tax considerations and not the other way around. Superficial losses can happen year-round, and knowing the rules can ensure that crystallized losses can be used for their intended purpose: tax savings.
CDA and Capital Losses
When considering triggering capital losses in an investment holding company for a current tax benefit — to offset capital gains in the year or to carry forward or back — think about the CDA. You need to clean out any positive balance in the CDA before triggering the capital loss.
Potential collateral damage of this planning may be to impair the ability to use CDA additions resulting from the receipt of life insurance proceeds in the future.The CDA is a notional tax account available to private corporations. Its purpose is to track certain tax-free surpluses accumulated by a private corporation, such as:
•the tax-free portion of capital gains in excess
of capital losses;
• the tax-free portion of dispositions of eligible capital property (like goodwill);
• capital dividends received from other corporations; and
• life insurance proceeds received by the corporation as beneficiary on the death of the life insured in excess of the policy’s adjusted cost basis (ACB).
These surpluses may be distributed in the form of tax-free capital dividends to the shareholders of the corporation who reside in Canada.
The CDA balance at any given time is the cumulative sum of the various CDA components minus the total of all capital dividends paid by the corporation before that time. Let’s look at an example where Holdco is
contemplating realizing capital losses in its portfolio and the impact this might have on the CDA balance.
In 2019 Holdco realized a capital gain of $1 million resulting in a credit to the CDA of $500,000. In 2020 Holdco is considering capital loss planning. Due to the economic environment resulting from COVID-19 there is the possibility of triggering some capital losses. Holdco declares a capital dividend to the shareholder of $500,000. The CDA balance is now at zero. Holdco disposes of some of its underwater investments and triggers a capital loss of $400,000. There would be a $200,000 reduction to the portion of the formula relating to capital gains and losses. Although this has no immediate tax consequences, it may prevent the distribution of all of the CDA credit arising from the receipt of life insurance by the corporation in the future.
Continuing with our example, if in 2021 the corporation receives a $500,000 death benefit of a life insurance policy with no ACB, the credit to the CDA
will be $500,000. But only $300,000 may be paid out as a capital dividend because at that point the cumulative CDA balance would be calculated as follows:
$300,000 Excess of non-taxable portion of
capital gains over non-deductible portion of capital
losses (+500,000 – 200,000)
$500,000 Plus excess of life insurance proceeds
over the ACB of the policy
($500,000) Less cumulative capital dividends paid by
$300,000 CDA balance at the time
Even where capital losses exceed capital gains and there is a negative balance in that part of the formula (negative amounts in the formula are deemed to be nil), this would not necessarily limit the payment of life
insurance proceeds received subsequently to be paid as a capital dividend. But it could do so, depending on whether capital dividends had been paid, for example, in respect of a prior capital gain. Again, let’s look at a
If the capital loss realized in 2020 was $1.2 million, resulting in a $600,000 reduction in that portion of the CDA formula, and everything else remained the same as in the situation above, the CDA balance would be
0 + $500,000 –$500,000 = 0. So, no ability to distribute the life insurance proceeds via a capital dividend at this point. However, in this example if
there had not been a prior distribution of capital dividends, there would be the ability to distribute the full life insurance proceeds. So, in our example the CDA balance would be 0 + $500,000 + 0 = $500,000.
Triggering capital losses may be top of mind for some investment holding companies to capture current tax benefits. However, don’t forget to consider the impacts this planning could have on the ability to later distribute capital dividends arising from life insurance. Because the calculation is cumulative, there could be a lot of water under the bridge by the time a death benefit is payable. Furthermore, it is not a well-known
fact that even though one factor can fully credit the CDA, another factor can prevent the ability to distribute all that credit.
While an economic downturn may bring about financial challenges to many businesses, it may also provide some great tax planning opportunities, especially as it relates to capital losses. Helping clients
recognize and navigate through these considerations can help increase an insurance advisor’s value proposition as well as lead to more insurance planning opportunities. ©
Written by Hemal Balsara, CPA, CA, CFP, TEP, Toronto-based
assistant vice-president, Regional Tax, Retirement and Estate
Planning Services, Individual Insurance, at Manulife Financial.