Introduction – Taxation of Capital Gains in Canada
Generally, when a taxpayer disposes of a capital property—e.g., real property, corporate shares, a partnership interest, mutual funds, etc.—and realizes a capital gain, the taxpayer must include one-half of the gain in his or her income. In other words, only half of a capital gain is taxable.
If, on the other hand, the taxpayer sells the property at a loss, the taxpayer may deduct one-half of the loss from the taxable portion of any capital gain. So, only half of a capital loss is an allowable deduction, and the deduction may only be used to offset taxable capital gains. That is, allowable capital losses generally cannot be used to offset, say, business income or employment income. (There are exceptions, however. For instance, if a deceased taxpayer has allowable capital losses remaining even after applying all available carryovers, the excess losses may offset any source of income on the deceased's income-tax return for the year of death or for the year before the year of death. Another example: an allowable-business-investment loss (ABIL) is a specific defined type of capital loss that may be deducted from any source of income.)
Two amounts are used to compute the balance of a capital gain or loss. The first is the adjusted cost base (ACB), which is the taxpayer's tax cost for acquiring a capital property. The second figure is the taxpayer's proceeds for disposing of the capital property. The ACB, when deducted from the proceeds of disposition, determines the amount of a capital gain or loss when a taxpayer disposes of a capital property. For example, a taxpayer buys a rental property for $100,000 and sells it a few years later for $150,000. In this case, the taxpayer's adjusted cost base is $100,000 and the proceeds are $150,000. The taxpayer therefore realizes a capital gain of 150,000 - 100,000 = $50,000. The taxpayer must report one-half of the gain—i.e., $25,000—as income. Say instead that the taxpayer sold the property for $75,000. The taxpayer will then realize a capital loss of 75,000 - 100,000 = $25,000. The taxpayer may deduct one-half of the loss—i.e., $12,500—from any other realized capital gain. (Transaction costs would also affect the capital gain or loss computation.)
Canada's Income Tax Act may, however, adjust a taxpayer's tax cost or proceeds of disposition. Notably, subsection 69(1) of the Income Tax Act may stipulate that a taxpayer's ACB is an amount other than the price that the taxpayer actually paid to acquire the property. The rule may also deem a taxpayer to have received proceeds other than the actual sale price. Subsection 69(1) applies to gifts and non-arm's-length transactions, and, for some taxpayers, it may give rise to unexpected capital-gains tax.
This article examines the tax implications of subsection 69(1) in the context of a gift and in the context a non-arm's-length transaction that deviates from fair market value. The article concludes by providing tax tips.
Tax Implications of Gifting Capital Property: Deemed Fair-Market Proceeds for Donor & Bumped Up ACB for Recipient
The capital-gains implications of a gift are set out in subparagraph 69(1)(b)(ii) and paragraph 69(1)(c) of Canada's Income Tax Act. These rules apply to gifts either between related parties (e.g., parent/child, corporation/shareholder, trust/beneficiary, etc.) or between arm's-length parties (e.g., charitable donation).
Basically, when a taxpayer gifts a capital property, the rules deem the donor to have received fair-market-value proceeds, and they deem the recipient to have acquired the property at fair-market-value cost. In more detail, when a taxpayer donates a capital property, the taxpayer is deemed, for tax purposes, to have received fair-market-value consideration—specifically, the fair market value of the gifted property, as determined at the time of the gift. Therefore, if, at the time of the gift, the donor's tax cost for the gifted property was less than the property's value, the donor will realize a taxable capital gain. The recipient, in turn, is deemed, for tax purposes, to have acquired the property at a tax cost equal to the property's value.
So, while these rules may trigger a capital gain for the donor, they accordingly bump the recipient's tax cost. This means that, should the recipient later dispose of the property, the recipient doesn't incur capital-gains tax on any gains that had accrued when the donor owned the property.
Tax Implications of Non-Arm's-Length Transactions Deviating from Market Value: Adjustments Resulting in Double Tax
Subparagraph 69(1)(b)(i) and paragraph 69(1)(a) govern non-arm's-length transactions generally. These rules aim to divert related taxpayers from manipulating tax outcomes by entering transactions that stray from market value.
Under these rules, if a taxpayer disposes of anything to a non-arm's-length party for nil consideration or below-fair-market-value consideration, that taxpayer is deemed, for tax purposes, to have received fair-market-value consideration.
On the other hand, if a taxpayer acquires anything from a non-arm's-length party for consideration exceeding fair market value, the taxpayer is deemed, for tax purposes, to have acquired the property at fair market value.
These rules asymmetrically adjust a taxpayer's cost and proceeds for capital-gains purposes. And by doing so, they effectively sanction non-arm's-length transactions that deviate from fair market value. To illustrate: Suppose X and Y are non-arm's-length parties. X owns land, which he acquired at a cost of $80,000. In year one, the land's value has increased to $120,000, yet X sells the land to Y for $100,000. X will be deemed to have sold the land for proceeds of $120,000, and X will realize a capital gain of $40,000 ($120,000 minus $80,000). But Y's cost to acquire the land remains at $100,000 because the deeming rules do not increase the cost when a taxpayer, like Y, acquires something at below fair market value. In year two, Y sells the property for $130,000, and Y will realize a capital gain of $30,000 ($130,000 minus $100,000). When we look at X and Y together, they incur a total capital gain of $70,000 ($40,000 plus $30,000), yet the actual gain accrued to the land is $50,000 ($130,000 minus $80,000). So, X and Y are double taxed on $20,000 of the actual accrued gain. That is, they are double taxed to the extent that their transaction deviated from the land's fair market value.
The rules similarly double tax a non-arm's-length transaction above fair market value. (By artificially inflating the recipient's tax cost for the property, such a transaction might be intended to, say, manufacture a capital loss when the recipient ultimately sells.) Suppose again that X and Y are non-arm's-length parties, and that X owns land that he acquired at a cost of $80,000. This time, in year one, while the land's value has increased to $120,000, X sells it to Y for $125,000. X's proceeds remain at $125,000 because the deeming rules do not decrease the proceeds when a taxpayer, like X, sells something above market value. So, X will realize a capital gain of $45,000 ($125,000 minus $80,000). Yet the rules will reduce Y's cost to $120,000. As a result, X and Y are double taxed on the $5,000 that their transaction deviated from the land's fair market value.
These rules apply only if parties deal on non-arm's-length terms. The Income Tax Act deems related taxpayers (e.g., spouses, corporation/majority shareholder, trust/beneficiary) to have been dealing on non-arm's-length terms. So, subsection 69(1) will apply to transactions involving those taxpayers. Still, the facts and circumstances surrounding a transaction will ultimately determine whether it took place on arm's-length terms. This means that subsection 69(1) may also apply to taxpayers who aren't otherwise related. To discern whether a transaction took place at arm's length, courts look at three criteria: (1) whether a common mind directed the bargaining for both parties to the transaction; (2) whether the parties to the transaction acted in concert without separate interests; and (3) whether any party could exercise de facto control, influence, or authority over the other with respect to the transaction. In addition, after applying these three tests, a court may also test the soundness of the overall result by considering whether the transaction terms reflected "ordinary commercial dealings." (R. v. Remai Estate,  2 CTC 120, 2009 DTC 5188 (FCA), at para 34.) This means that a transaction involving below-market-value consideration may by itself suffice to show that the parties dealt on non-arm's-length terms.
Tax Tips: Rollover Exceptions & Tax Planning
The Income Tax Act contains various exemptions that oust the above deeming rules. For instance, under subsection 70(6), by default, a transfer of property between spouses occurs on a cost basis—that is, the transferor is deemed to receive proceeds equal to cost, so there's no gain, and transferee inherits the transferor's tax cost for the property. Likewise, when a taxpayer transfers certain assets to a corporation, subsection 85(1) of the Income Tax Act allows the taxpayer and the corporation to jointly elect the amount at which each asset is transferred. The election allows either a complete rollover or, if the taxpayer so desires, a partial realization of an asset's accrued gains. Section 86 permits a similar tax-deferred rollover to facilitate a corporate reorganization.
But these transactions demand attentive tax planning. For instance, a spousal transfer may trigger an income or capital-gains attribution rule section 74.1 or section 74.2. And income-tax jurisprudence features a steady stream of taxpayers who triggered unforeseen tax liability when blundering a corporate reorganization. So, if you anticipate entering a transaction with a related party, or if you wish to avoid tax-planning mistakes, meet one of our seasoned Canadian tax lawyers to discuss your options.
Moreover, even if you make best efforts to deal on fair-market terms, the Canada Revenue Agency may reassess you should the CRA disagree with your valuation. You can avoid these sorts of problems by obtaining a professional valuation of the asset and by inserting a price-adjustment clause in the relevant agreements. Still, the CRA will respect such a clause only if the parties meet certain conditions. For instance, the parties must genuinely intend to transfer the property at fair market value. For advice on strategies allowing you to respond should the CRA challenge valuation, consult one of our top Canadian tax lawyers today.