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The past two weeks have seen frenzied buying and selling of stocks with minimal intrinsic value but high speculative interest in the “shorts market,” where traders sell stocks first, hoping to buy them back later at a cheaper price. As with all financial transactions, there are consequences. The tax officer is waiting around the corner.
Speculators drove up GameStop, AMC Entertainment and Blackberry prices through platforms like Robinhood Markets Inc., which brought a flurry of first-time dealers to the stock market. The hype created and destroyed billions of dollars in paper assets. GameStop shares hit $ 483 on Jan. 28, down from $ 18 per share three weeks ago, and fell to $ 47.81 by Feb. 9. Some traded their cars while they stopped at a red light.
People have the right to buy what they want on the stock exchange. As Harvey Pitt, a former SEC chairman, said (WSJ Feb. 8, 2021), “You can sell junk to the public as long as you tell the public, ‘This is junk and you’d be an idiot to buy it, but Would you like to buy it? “. The Canada Revenue Agency (“CRA”) agrees as long as people are willing to pay their taxes. This is where the hidden tax trap lies.
A rationale of the exchange is that there is a buyer for every sale, which makes it an efficient auction for trash too. However, as with music chairs, there are always some left over when the music stops. Investors who have sold their winners can party, but must set aside cash for tax payments when due. There is no withholding tax at source on stock deals, so winners should set aside some money for the tax officer. Traders who have bought high and sold low need to consider what to do with their losses.
A common misconception among stock traders is that all income is equal and taxable. Nothing is further from the truth. The fundamental characteristic of the Canadian income tax system is that we have to calculate our income from each source separately and put each source in different silos to which we then apply different rules and rates. Rates for individuals vary from 0 to 54%.
For tax purposes, business income is a separate source of income from capital gains. The distinction between the two is crucial. Business income is fully taxable and business losses are fully deductible from other income. Capital gains are taxed at the lower effective tax rates and in some cases are entirely tax-free. The highest effective tax rate on capital gains is currently half the tax rate that applies to business income.
In the same calendar year, if an investor realizes capital gains of $ 100,000 and losses of $ 90,000 after sales, they have net income of $ 10,000, of which $ 5,000 is taxable. With a nominal marginal tax rate of 54%, its effective tax rate is 27%. On the other hand, $ 9,000 in capital gains and $ 10,000 in losses is a net loss of $ 1,000. The allowable loss is $ 500. However, there is a kicker. The loss of $ 500 cannot only be offset against capital gains (if any) in the year. The loss can be carried over to other years, but only to capital gains.
Which brings us to the critical question: what is a capital gain or loss? The Income Tax Act does not define this in a meaningful way either. Taxpayers need to fathom the difference between the two from case law, which is blunt for anyone who has not taken several advanced courses in tax law. The rating agency is also unaware of the distinction between the two. However, it has the advantage of being able to judge the taxpayer, who then bears the burden of proof and the costs of tax disputes, which in times without a pandemic can last anywhere from 3 to 5 years. In these days we can add another 2 years.
In theory, the difference between capital gains and income is simple. The income comes from the “trade”; Capital gains from the sale of “investments”. The courts use analogies to distinguish between the two. For example:
“The basic ratio of” capital “to” income “has been widely debated by economists, comparing the former to the tree or land, the latter to the fruit or harvest, the former as a reservoir from sources, the latter as an outlet stream measured by its flow rate over a period of time “.
The tree is the capital that produces an income (the fruit), and income is the profit made by selling the fruit. A profit from the sale of the tree itself is due to the capital.
The analogy is simple when it is obvious. For example:
- A rental building is capital; Rent from the building is income.
- Company stocks are usually capital; Dividends on the stocks are income.
- Corporate bonds are usually capital; Interest payments on the bonds are income.
So an investment represents capital and the flow from the investment represents income.
The problem in practice is that we need to determine whether the property is capital or is trading in inventory. The distinction between the two depends on the taxpayer’s intentions in purchasing the property. For example, a person who buys stocks with the intention of “turning them over” will generate business revenue if he sells the stocks. Conversely, if it purchases the shares as an investment, any gain or loss in selling them will be due to capital. Therefore, we need to objectively analyze her state of mind when she acquired the shares.
The key difference is the taxpayer’s operational intent at the time of purchasing the property. Did the taxpayer want to trade (do business) or invest (hold real estate)? An “investment” is an asset or property that is purchased with the intention of holding it or using it for income. In tax law, an investment is a means to an end. When a taxpayer purchases real estate with the intention of trading – that is, buying the property at a profit and reselling it – any gain or loss from the trade is business income (loss). Hence, “flipping” stocks suggests trading for business income.
The distinction between trading and investing does not depend on the taxpayer’s desire to make a profit. Nobody wants to make a loss. Everyone wants to make a profit, regardless of whether they trade or invest. Trading implies a profit system to generate income by buying and selling real estate. An investment involves acquiring and holding an asset for its potential return, but with the expectation that the investment can eventually be sold for a profit.
For example, suppose a person buys shares at $ 40 per share and their value increases to $ 400 per share. The characterization of the profit of $ 360 depends on his intention at the time of buying the shares. If his usual practice is to buy and sell stocks for trading purposes, the $ 360 profit is business income from trading his real estate holdings. However, if he buys the shares as an investment and sells them when his plans change, the profit is a capital gain and only $ 180 is taxable. The flipping of stocks is evidence of trading intent.
Every seller has a buyer. If the buyer who bought the shares at $ 400 per share sells when the shares fall to $ 10, the loss of $ 390 is imputed by the same rules. The loss is fully deductible if it is for business reasons, but only $ 195 is deductible if it is on the principal. In the latter case, however, there is the additional kicker. The capital loss of $ 195 can only be offset against other capital gains.
From the examples above, it is understandable that individuals prefer to characterize their gains as capital gains and their losses as business losses. The rating agency takes the opposite view and wants to characterize profits as business income and losses as capital losses. That’s why taxpayers end up in court.
So how do we determine a taxpayer’s intentions when buying and selling real estate, or vice versa? The only coherent rule is: no single factor is decisive. We need to examine the circumstances of the transaction and reconcile several pieces of information to determine the taxpayer’s intent. As one judge said, “… a reasonable appreciation of all guiding characteristics will provide the ultimate answer.” The common sense answer becomes clear when the judge pronounces it. Until then, however, taxpayers need to determine the answer before filing their tax returns, and not with the benefit of ex post analysis
The intent analysis is even more complicated when the taxpayer has a secondary trading intent in acquiring the shares. If a taxpayer has a secondary trade intent, any gain or loss from the trade is also a business income. Therefore, a taxpayer claiming that a profit is a capital gain must demonstrate two things: (1) that his primary intention at the time the transaction was closed was to make an investment; and (2) that at that time he had no secondary intention to trade in the particular property.
Here we see the problem with flipping stocks. We determine this using a balance of probabilities. Hence, the credibility of taxpayers is always in question. Speculators at GameStop would have to show that their primary and secondary intentions were to invest, not trade, which could be difficult for those who trade their cars while standing at a red light.
Originally published by Tax Chambers, February 2021
The content of this article is intended to provide general guidance on the subject. A professional should be obtained about your particular circumstances.