What is a capital gain?

Prior to 1972, capital gains were not taxed.

Over the last 44 years, however, Canada’s Department of Finance has introduced various measures impacting the reporting and taxation of capital gains (see this chart for a comprehensive summary of those measures and their dates).

Read: Principal Residence Exemption: What’s changed, what hasn’t

Capital gain or income receipt?

Determining if a receipt is on account of income or capital is not simple. In fact, since 1972, there have been many Tax Court cases focused on determining if a receipt was on account of capital or income.

The Income Tax Act does not define “capital gain.” To report a capital gain, the property disposed of, or deemed disposed of, must be capital in nature. However, “capital property” is also not defined, and the determination of whether a receipt is on account of capital or income is dependent upon the nature of the property and the manner in which the taxpayer holds the property.

Read: Capital Dividend Account changes now proceeding

While taxpayer intent — the primary purpose behind the taxpayer purchasing the property — is always a key determinant, CRA and the courts also look to the following guidelines when evaluating a transaction to determine if the taxpayer should report on account of capital or income:

• Period of ownership. Property held for a long period is more likely to be deemed capital.
• Frequency of transactions. Regular, similar transactions are more likely to be deemed income than a single, one-time transaction.
• Relationship of the transaction to the taxpayer’s ordinary business or income. A stockbroker who researches positions and trades securities daily may report such dispositions on account of income. Meanwhile, a medical doctor who sells a particular security position held for three years based upon the stockbroker’s guidance may report such a disposition on account of capital.
• Improvement and supplemental work on the property to position for sale or to retain over a longer period. If improvements are made to capital property to prolong its overall use or period of ownership, such expenditures lend themselves to being on account of capital.

A common analogy that tax advisors use to differentiate capital versus income property is a fruit tree: the tree itself is capital property (it is bought infrequently and held for a long period). So, if the tree or orchard is sold, it is on account of capital. Meanwhile, payments for the fruit borne by the tree are income receipts that a fruit farmer regularly generates on account of income, business or adventure in the nature of trade — not on account of capital.

Read: How to fix TFSA overcontributions

Chart: Capital gains measures over the years

Important date(s)	Impact	Capital gains inclusion rate
December 31, 1971	Valuation day: Unrealized capital gains on capital property held on this date were not taxable. The FMV of capital property held on this date represents its adjusted cost basis on a go-forward basis	0%
January 1, 1972	Capital gains now a taxable income receipt	50%
January 1, 1972 to December 31, 1987		50%
January 1, 1982	Only one Principal Residence Exemption per family unit
January 1, 1985	Introduction of $500,000 Lifetime Capital Gains Exemption
January 1, 1988 to December 31, 1989		66 2/3%
January 1, 1990 to February 27, 2000		75%
February 22, 1994	Elimination of general capital gains exemption on first $100,000 of capital gains; $500,000 for qualified small business corporation shares and farm property remained
February 28, 2000 to October 17, 2000		66 2/3%
October 18, 2000 to present		50%
May 1, 2006	$500,000 capital gains exemption expanded to include qualified fishing property
March 19, 2007	Capital gains exemption raised from $500,000 to $750,000
January 1, 2014	Capital gains exemption raised from $750,000 to $800,000 on qualified small business corporation shares, and will be indexed annually
April 20, 2015	Capital gains exemption raised from $750,000 to $1,000,000 for qualified farm and fishing property (no indexing)

Let’s look at how tax legislation applies to clients who hold investments in open, non-registered accounts.

Today, if a client disposes of a particular security held on account of capital, the capital gain (proceeds of disposition less the adjusted cost basis) is included for income tax purposes at 50%. Capital gains are reported on Schedule 3 for individual taxpayers, Schedule 6 for corporate taxpayers and Schedule 1 for trusts.

As mentioned, a capital gain is calculated as proceeds of disposition (POD) received less adjusted cost basis (ACB) paid by the taxpayer. However, sometimes there are adjustments to POD and ACB. Here are a few adjustments clients should consider as they relate to investment securities held in open, non-registered accounts.

ACB considerations

Identical property

When determining the capital gain from the disposition of Canadian securities, the identical property rule is taken into account when calculating the ACB of units sold using a weighted-average cost.

Identical property is the same in all material aspects, so that a prospective buyer would not have a preference for one as opposed to another. To determine which properties are identical, compare the inherent qualities or elements that give each property its identity.

Here’s an example. Say Mrs. Smith bought 1,000 units of Fund A on January 15 for $10,000, 325 units on March 15^th for $4,000, and received 30 units worth $400 at year-end. Her annual T5 reported an eligible dividend of $300 and a capital gain dividend of $100. On December 27, Mrs. Smith sold 500 units for $6,000. What is her capital gain?

Since the units are identical property, the formula for ACB is total cost divided by number of units.

($10,000+$4,000+$400)/(1,000+325+30) = $14,400/1,355 = $10.63/unit

Then, the capital gain is POD minus ACB:

$6,000 – (500*$10.63) = $685

Commissions

Commissions paid to brokers relating to the purchase of a particular security position are on account of capital and are added to the ACB of the securities purchased. A commission is not to be confused with advisory fees relating to the provision of investment counsel.

Read: Investment fees — what’s deductible?

DRIPs

Where securities are acquired through a dividend re-investment plan (DRIP) or received in kind to support an income distribution, the FMV of the dividend/distribution used to purchase additional shares or units represents additional ACB. The additional shares or units are deemed to be acquired with after-tax dollars, since the dividends or distributions are taxable income in the hands of the investor.

Here’s an example. Say Mr. Jones bought 4,000 shares of Corp on January 5 for $50,000. On January 15, he received an eligible dividend of $1,200, and $1,150 was used to purchase an additional 90 shares through Corp’s DRIP. On July 15, he received another eligible dividend of $1,200, and $1,190 was used to purchase 85 shares through Corp’s DRIP. What was the ACB of Mr. Jones’s shares on December 31?

($50,000+$1,150+$1,190)/(4,000+90+85) = $52,340/4,175 = $12.54/unit

POD considerations

Commissions

Commissions paid to brokers relating to the disposition of a particular security position are, again, on account of capital. As this expenditure relates to the disposition of capital property, it is not an income deduction, and reduces the POD received from the securities. Once again, a commission is not to be confused with advisory fees relating to the provision of investment counsel.

Here’s an example. Say Mr. Donald’s broker purchased 1,000 shares of Corp for $40,000 on February 15 and the brokerage charged him a $75 commission for the purchase transaction. On September 30, he sold 1,000 shares of Corp for $40,500 and was charged another $75 commission for the disposition. What was Mr. Donald’s capital gain?

POD – ACB = ($40,500-$75) – ($40,000+$75) = $350

Next time, we’ll examine exceptions and special issues when calculating capital gains. (Read Part 2 here.)