Mew & Company Chartered Accountants in Vancouver provides businesses with tax advice:
One of the most commonly disputed tax issues is whether a gain from a transaction is considered as business income or as a capital gain. The reason for this dispute is due to the tax implications of each type of gain we’re talking about. If a gain is considered business income, the entire gain is taxable. If a gain is considered a capital gain, only half of the amount is taxable. Therefore for any gain, the taxpayer will always want to argue in favor of a capital gain classification.
On the flip side, when there is an unforeseen loss from the transaction, the taxpayer would want to classify the loss as a business loss because the entire amount of the loss can be used to offset income from all sources. Conversely, if the loss is a capital loss, only half of the loss is available to reduce your income. In addition, capital losses can only be used to reduce capital gains, not other types of income, which further limits the tax benefits of a capital loss.
Assets are purchased and sold all the time by businesses and individuals. A grocery store sells groceries and an electronics store sells electronics, both for a profit. There is no question that gains from these activities are business income. Similarly, many Canadian individuals and businesses hold real estate to generate rental income for years and the properties are sold upon retirement of the owners. There is no question that the gains from the sale of the rental units are capital gains and hence only fifty percent taxable.
However, the history and intention of many transactions, particularly those involving real estate, are not always straight forward, leading to disputes with CRA on the classification of the gain.
A common example is a taxpayer, whose profession is a carpenter, acquiring a piece of land and house. The taxpayer does a major renovation to the house to makes it rentable to an arm’s-length party. After renting the house for two years, the taxpayer sells the house for a considerable gain.
When an asset is acquired and the intention of the taxpayer was to sell the asset at a later date for a gain, this gain would be considered business income, fully taxable. However, when an asset is acquired and the intention of the taxpayer was to use the asset to produce income, which is what happens when a taxpayer rents the property out to a tenant, the sale of the asset at a later date for a gain would be considered a capital gain. There is no question that the taxpayer would want to classify the gain as capital.
In this situation, CRA generally starts with the intention of the taxpayer when the asset was purchased. In some situations, the intentions are evident by written contracts and external verification. However, when CRA can only rely on the taxpayer’s words to prove intention, it looks at other factors to determine how the transaction should be treated.
Factors contributing to the treatment of business income include the following: the real estate transaction is related to the taxpayer’s work as a carpenter; supplementary work was done on the asset to enhance its value and marketability; and the length of the ownership period was relatively short.
Factors contributing to the capital gain treatment include the following: the capital was put up for rent for two years. Of course, if the taxpayer can prove that the original intention was to hold the asset much longer but had to sell the assets for unforeseen reasons such as a marital breakdown or financial hardship, the tax court may very well side with the taxpayer.
The simple example above demonstrates why the business income versus capital gain dispute is so common between taxpayers and the CRA.
If you have already purchased an asset and the intended plan changes due to unforeseen circumstances, talk to your professional tax advisor to ensure you take the right steps to optimize tax treatment in your favor.
If you have any questions or want to know about how we can help you, contact us.
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