Is it business income or capital gain? The distinction is important because business income (or loss) gets included in income at 100%, whereas a capital gain (or loss) is only included in income at 50%. In other words, you would want to report losses on account of business, and gains on account of capital, to minimize your tax payable.
Business Income vs. Capital Gains
So how do you determine the difference between capital property and inventory? Here are three things to keep in mind:
- The normal course of business:
If the transaction is similar to the normal course of business, it may be considered business income. - The frequency of the transaction:
The more frequently you engage in the transaction in question, the more likely the CRA will consider it on account of business. - The adventure in the nature of the trade:
Income from an adventure or concern in the nature of trade is treated like business income. If what you are doing is an "adventure in the nature of trade," then your gain will be fully taxable.
You can determine if the transaction is an adventure or concern in the nature of trade by:
- Whether you've dealt with the property in the same way as a dealer ordinarily would;
- Whether the nature and quantity of the property excludes the possibility that its sale was of a capital nature; and
- Whether the taxpayer's intention is consistent with the other two tests pointing to a trading motivation. If the primary intention is said to be the holding of the property as an investment, CRA considers if there was a secondary intention to sell the property when the primary intention could not be fulfilled.
Shares
CRA generally accepts that most people hold shares of corporations and other securities, such as bonds and mutual fund units, as capital property. Capital gain or loss is subject to preferred tax treatment whereby only 50% of the gain is included in income and taxes.
However, if you trade shares on a regular basis and hold them for only short periods, you might be found to be in business, in which case your gains would be fully taxable.
You can avoid this situation by filing a "Canadian securities election" on Form T123 with your tax return, so that all Canadian securities you hold are deemed to be capital property, forever.
Real estate
As you can imagine, the most difficult issues with regards to business or capital income usually arise with respect to real estate. You might build a home to live in (capital), but also with plans to sell it (inventory). Paragraph 3 of the CRA's Interpretation Bulletin IT-218R sets out 12 factors that the CRA considers relevant in determining the intention with respect to the property. The courts also have developed the concept of a "secondary intention," as discussed above.
Principal residence
The gain on a principal residence is normally completely exempt from tax. Many small homebuilders have tried building a home, moving in, selling it, and moving on to another home, repeating the process a few times. If you do this, the CRA will determine that you do not have an exempt capital gain after all. Instead, you are treating each home as "inventory," and you will be fully taxed on the gain as business profit.
Note: If you haven't kept all of your receipts for the costs of construction, you might have a hard time proving that your profit was less than what the CRA claims it was! You might also be required to pay GST or HST on the entire value of the new home.
The CRA has been known to go after builders even 10, 15, or 20 years. If you are in this situation, consider making a Voluntary Disclosure before CRA comes calling.
For more information on salary, dividend, and compensation strategies, you can reference CPABC Tax Tips. If you have any questions about such compensation, be sure to contact Sidhu & Associates chartered professional accountant.