Your mother always taught you that it was best to share, and she was right. Sharing capital losses with your spouse or with an affiliated entity can save you money. If one spouse or affiliated entity has capital gains, and the other has losses, transferring the loss to the one with the gains will take advantage of deductions now instead of later. This is done through the use of the superficial loss rules in the Income Tax Act (the "ITA"). These loss sharing provisions also work for corporations and partnerships affiliated with each other.
This year's global economic crisis has affected the financial position of many people and businesses. The recent downturn has had a substantial effect on the stock market, gas prices and the Canadian dollar. Capital losses accrued now can be useful in offsetting any capital gains which may have been accrued during the recent period of strong economic growth in Canada.
If you have no capital gains in the past three years, you might want to transfer the loss to an affiliated person who can use it now, rather than hang on to an asset which has decreased in value. Using the transfer provisions in the ITA is a way to get the tax benefits of capital losses as soon as possible, taking advantage of the time value of money. This is done by following some simple steps and using the superficial loss rules in the ITA.
Who Can Take Advantage Of The Transfer of Losses
Losses are generally intended by the ITA to be allocated to the taxpayer who accrued them. The ITA sets out limited circumstances in which it allows affiliated persons to share losses. The ITA defines an "affiliated person" as a spouse or common-law partner, a corporation, partnership or trust of his or her spouse, or even two corporations or partnerships controlled by the same person or group of people.1 The definition of affiliated persons does not include parents, children or other family members of a taxpayer.
Basic Loss Transfer Transaction - Superficial Loss
The transfer of a capital loss is carried out by using the superficial loss rules, along with the "affiliated persons" definition and various provisions of the capital gains and losses sections of the ITA.2
In the basic loss transfer transaction a person sells a capital asset, and within 30 days before or after the sale, an affiliated person purchases an identical asset. The affiliated person must hold the asset until at least 30 days after the sale by the original owner, and thereafter can sell it. The affiliated person's adjusted cost base for the asset is the same as that of the original owning spouse; so the loss accrued by the affiliated person is the difference between the original price of the asset (what the first owner bought it for), and what the affiliated person then sells it for.
When an affiliated person purchases the same asset within a short period of time, the ITA deems any gain or loss (to the original owner) on the sale to be nil; this is called a "superficial" gain or loss.3 The rules relating to a superficial loss are meant to prevent spouses or affiliated persons from accruing losses on capital assets while retaining control of the asset (i.e. selling shares to accrue a loss, but having a spouse purchase the same shares and holding them until the price goes back up).
Unlike the direct transfer of property between spouses, which would result in an automatic rollover and attribution of any gain or loss on sale back to the transferor spouse, this fair market value sale and repurchase of an asset by spouses transfers the gain or loss from one to the other.
Where an asset is fungible, it is easiest to sell it on the open market and have the affiliated person purchase the same asset on the open market. This will show a legitimate transaction and avoid triggering the automatic rollover provisions. However, if the asset is not easily replaced or interchangeable (for example shares not available on a public stock exchange), then a sale between spouses at fair market value may be used. The sale must be legitimate and plausible; an interest-bearing promissory note or something equally constituting valid payment at fair market value should be used to track the payment for the item from one spouse to the other.
Benefits of Transfer: Using the Deduction Now Rather Than Later
The following is a basic example of how a capital loss transfer transaction would work between spouses. A similar transaction can be effected between other affiliated persons.
If a husband, who bought shares at $100 which are now only worth $60, were to sell his shares this year he would accrue a capital loss. If he did not have capital gains to offset the loss this year or within the last three years, and his wife did have gains during that time, the couple should take advantage of the loss transfer provisions.
The husband would sell his shares on the open market for fair market value ($60). The wife, who has had capital gains, within 30 days before or after her husband sold the shares, would buy the same amount of shares at fair market value ($60). The ITA deems the husband's loss on the sale of his shares to be zero, and the wife's adjusted cost base for her shares to be the same as her husband's before he sold his shares ($100 - even though she only paid $60 for them). After holding them until at least 30 days after the sale by her husband, the wife sells the shares on the open market for fair market value, and accrues a loss of the adjusted cost base less the sale price. So if she sells her shares at $60, she would accrue the same $40 loss that would have been attributed to her husband had they not undertaken to transfer the loss to her. Once the transfer has been effected, the wife can use the $20 of allowable capital losses that year (or carried back three years), thus gaining tax savings for the couple now instead of sometime down the road.
As noted above, this type of transaction can also be effected between an individual and a corporation, partnership or trust controlled by him or herself or his or her spouse, or corporations and partnerships which are affiliated with each other.
Transaction Must be Legitimate
The Canada Revenue Agency has given loss utilization transactions such as these the go-ahead. In 1995, the CRA released Technical News #3, which confirmed that loss utilization schemes between corporations to obtain a tax benefit are acceptable, and do not trigger Section 245 (the anti-avoidance provision of the ITA). However, Technical News #30 further explained that the transaction must be plausible and legal. In the case of individuals, the transactions are more likely to be done on the open market, thus ensuring the legitimacy of the transaction.
Using this type of transaction can be very helpful in this economic climate, where substantial losses are being accrued by couples or affiliated entities, who have perhaps had gains in the past few years. Transferring a capital loss can mean a tax saving now instead of some time in the future, so it is a simple way to take advantage of the time value of money, not to mention proving that it pays to share.