Tax Treatment Of Expropriated Property and Replacement Property
Subsections 13(4) and 44(1) of the Income Tax Act permit a taxpayer to elect to defer the recognition of income or capital gains where a "former property" is involuntarily disposed of, or a former property that is a "former business property" is voluntarily disposed of, and a "replacement property" is acquired.
These provisions allow taxpayers that have disposed of property to defer the resulting tax consequences and relocate businesses without incurring immediate tax consequences. Where the former property (other than eligible capital property) has been involuntarily disposed of, for example, stolen, destroyed or taken under statutory authority, the replacement property must be acquired within two years of the end of the taxation year in which the disposition of the property is deemed to have occurred and proceeds to have become receivable.
For income tax purposes the expropriation of property, or its destruction or theft, is deemed to be a disposition giving rise to a capital gain or recapture of capital cost allowance (depreciation). To the extent that a taxpayer receives the insurance proceeds on destroyed or stolen property, or expropriation proceeds from the government which is expropriating, and keeps those funds without replacing the property, then it is appropriate for tax to be paid on any capital gain or recapture. However, to the extent that the taxpayer goes out and acquires a replacement property, it would be unjust to charge tax.
Where the property is former business property and the disposition is voluntary, or eligible capital property, the replacement property must be acquired within one year of the end of the taxation year in which the disposition occurred (for depreciable property or eligible capital property) or when an amount becomes receivable as proceeds of disposition for capital property. The replacement property must be acquired to replace the former property, have the same or similar use as the former property and, if the former property was used for the purpose of gaining or producing income from a business, the replacement property must be acquired for the purpose of producing income from the same or a similar business.
A "former business property" as defined in subsection 248(1) is capital property that is real property or an interest therein that is used by the taxpayer or a person related to the taxpayer primarily for the purpose of gaining or producing income from a business but generally does not include rental property.
Where such a former property was expropriated the replacement property can be acquired at any time after the taxpayer receives notice of an intention to expropriate and before the end of the 2 year time period stated above.
There is no requirement in the Tax Act that the replacement property be acquired after the former property is disposed of, but the property must nevertheless qualify as a replacement property.
A taxpayer must elect to have the provisions of subsections 44(1), 13(4) and 14(6) apply. The election should be made as follows:
- If the disposition and replacement take place in the same year, the taxpayer's calculation (in the income tax return for that year) of the recaptured capital cost allowance, the amount under subsection 14(5) by reason of subsection 14(6) (that is, for purposes of determining the balance in the pool of eligible capital property - see the current version of IT-123), or the capital gain by virtue of subsection 44(1) will be considered to constitute an election.
- If the property is not replaced until a subsequent year, the election should take the form of a letter attached to the income tax return for the year the replacement property is acquired. The letter should include a description of the replacement property and the former property, a request for an adjustment to the recapture of capital cost allowance, the taxable capital gain reported, or the amount included in income by virtue of subsection 14(1) in a prior year, and a calculation of the revised recapture, taxable capital gain or cumulative eligible capital.
- If the replacement property is acquired prior to the year of disposition of the property, the election to apply subsections 13(4), 44(1) and 14(6) should take the form of a letter attached to the income tax return for the year in which the replacement property is acquired and the letter should include descriptions of the replacement property and the property that is to be replaced. If the taxpayer late-files such an election, it will be accepted if it is filed in the income tax return for the year in which the former property is disposed of, provided it is evident that the new property qualifies as a replacement property.
The Income Tax Act therefore effectively contains a rollover provision which applies when compensation is receivable in respect of capital property that has been stolen, destroyed or expropriated. Under these circumstances, a taxpayer is permitted to defer all or a part of any capital gain arising on such disposition by purchasing a replacement property. Any excess of proceeds received, for the expropriated or destroyed property, over replacement cost will be deemed to be the gain realized, and the unrecognized portion of the gain will reduce the cost, or capital cost, of the replacement property which is acquired. In this way, liability for tax on any gain arising from the disposition or deemed disposition of the former property is deferred until the disposition of the replacement property.
For these rules to apply, the taxpayer must have received proceeds of disposition of capital property in any of the following circumstances:
- As compensation for depreciable or other capital property that has been stolen,
- As compensation for depreciable or other capital property that has been destroyed, and any amount payable under a policy of insurance in respect of the loss or destruction of such property,
- As compensation for depreciable or other capital property taken under statutory authority (expropriated) or the sale price of such property sold to a person by whom notice of an intention to take it under statutory authority was given.
In order to qualify for the deferral of tax rollover a replacement property must be acquired. As stated above, the new property must be acquired before the end of second taxation year following the year in which the proceeds of disposition of the former property became receivable in the case of an expropriation.
A particular capital property is a replacement property if:
- It was acquired by the taxpayer for the same or a similar use as the use to which the former property was put by the taxpayer or a person related to the taxpayer; or
- Where the former property was used by the taxpayer or a person related to the taxpayer for the purpose of gaining or producing income from a business, the particular property was acquired for the purpose of gaining or producing income from the same or a similar business or for use by a related person for such purpose.
The fact that the specific funds received for the former property are used to acquire another property in no way bears on the determination of whether or not the acquired property constitutes a replacement. It also follows that where a taxpayer temporarily invests such funds pending a decision on the acquisition of a replacement property, the temporary investment would normally not itself constitute the replacement.
If a taxpayer exchanges one property for another, the new property will qualify as a replacement property provided it is in fact a replacement property and the other requirements are met.
As noted above, a taxpayer effectively has 2 years to acquire a replacement property for expropriation and one year for former business property. . If he does not acquire it in the year of disposition (expropriation or destruction) he will have to include the disposition on his tax return for the year. However, when a replacement property is acquired, he will be able to amend that return claiming the rollover.
If a replacement property is acquired for an amount which is greater than or equal to the insurance proceeds or proceeds of expropriation, then the effect of the rollover provision is to transfer the undepreciated capital cost (undepreciated asset cost) and the adjusted cost base for tax purposes into the new asset and to fully defer any capital gain or recapture as a result of the expropriated or destroyed asset. However, if the new asset costs less than the proceed from the old asset, then a partial capital gain or recapture will be recognized and the rest will be deferred.