A friend recently told me a story about a British manufacturer, Bodywise, which began selling Aeolus 7 to bill-collection agencies for about $6,000 (U.S.) a gram in the early '90s. The main ingredient in Aeolus 7 is pheromone adrostenone, which is secreted from a man's underarms and appears to be effective in getting debtors to pay up. In a study in Australia, invoices mailed out that had been treated with Aeolus 7 had a 17-per-cent higher return than untreated invoices.
So, my friend had an idea. He was wondering whether treating his tax return with Aeolus 7 would cause his return, which included some controversial figures, to be more readily accepted by the Canada Customs and Revenue Agency (CCRA) and speed up his refund.
"I don't know," I said, "and I don't want to even picture where you're going to get some of that Aeolus 7 from."
As it turns out, my friend is concerned that the CCRA could challenge the capital gains that he is reporting on his tax return. You see, he trades in securities so often that CCRA may have a good argument that his capital gains aren't capital gains at all. Let me explain.
Gains vs. income
For most Canadians, a profit realized on the sale of securities is going to be treated as a capital gain, just one-half of which is taxable if the gain is realized after Oct. 17, 2000. Likewise, any losses on a sale of securities is generally treated as a capital loss. Capital losses can only be used to offset capital gains, and are deductible at the same inclusion rate as the gain against which the loss is being applied.
The problem, however, is that where the volume of your trading activity is significant, the CCRA might hold the view that your trading activity constitutes a business. In this case, your profits and losses from trading will be considered business income and losses (income in nature), not capital gains and losses (capital in nature). The most significant result is that 100 per cent, and not 50 per cent, of your profits will be subject to tax. When earned personally, this is likely to result in more tax on those profits than if you had capital gains.
The taxman will take a look at a number of factors when determining whether your profits and losses are capital or income in nature. The following factors could point to your trading activities being a business.
You have a history of frequently buying and selling securities or other property.
You own the securities briefly.
You have extensive knowledge and experience in securities.
Your ordinary business includes trading in securities for others.
You spend substantial time researching potential purchases.
Your securities purchases are financed primarily on margin or by other debt.
You have advertised or made it known that you are willing to purchase securities.
You have purchased shares that are speculative or have low dividend yields.
The truth is, no single factor will determine how the CCRA will treat your profits and losses. But where a number of the factors above apply, the taxman might conclude that you're running a business.
If your trading activities are given business treatment, you'll be able to deduct a number of things that you will not otherwise be able to deduct as an investor facing capital treatment. I'm thinking of things like newspaper and financial magazine subscriptions, Internet connection charges, computer and software expenses related to your investing, telephone or long-distance charges related to your trading, and more. While this may sound appealing, it's not likely that those expenses will shelter as much of your profits as the 50-per-cent inclusion rate offered to capital gains.
One last point: It's possible to file an election to have all of your transactions in Canadian (but not foreign) securities treated as capital in nature.
To qualify you must be resident in Canada and must not be considered a "trader or dealer in securities" (which includes those who participate in the promotion or underwriting of a securities issue, those who hold themselves out to the public as a dealer in securities, or those who utilize special knowledge of a company that is not publicly available).
The problems with this election are that it will do nothing to provide capital treatment for your foreign securities, and the election is irrevocable -- so think twice before electing.
Here's the bottom line: You need to understand the tax consequences of your trading activities if you're going to trade actively.
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