Investing – Page 5 – Doug Carroll

Deductibility of securities trading losses

At issue

Business losses incurred in the course of securities trading may be deductible to a taxpayer where it can be shown that they arose while the person was either a “trader” as defined under the Income Tax Act, or was otherwise engaged in an “adventure in the nature of trade”. To determine whether this latter characterization applies, a court will generally weigh five factors:

Frequency of transactions
Duration of holdings
Intention to acquire for resale at a profit
Nature and quantity of securities
Time spent on activity

Whether considering any one of the factors or the set of five together, there is no bright line test to know for certain that a given taxpayer has satisfied the requirements. So while there is plenty of case law fleshing out these factors, taxpayers who are at odds with the Canada Revenue Agency are often left to plead their unique facts before a judge.

Here’s how a few taxpayers fared recently in litigation.

Walsh v. The Queen, 2011 TCC 341

Mr. Walsh had retired from his chartered accountancy practice due to health issues, but wished to continue in a business that was compatible with his skill set. Eventually he settled upon securities trading, purchased a sophisticated software package and participated in both online and in-person training and discussion groups.

For the two years in issue, there was only a small amount of trading activity, but this was not determinative against him.

The claimed expenses were not aggressive attempts to allocate household expenses to a home-office or the like, but were specifically related to the investing activity. The bulk of them were however for training, and the relative timing of the outlays was critical. Rather than being in the preliminary exploitation of a business opportunity, Mr. Walsh was held to be in a pre-exploitation stage, and therefore the $26,500 losses were held to be personal and not deductible.

Zsebok v. The Queen, 2012 TCC 99

The taxpayer filed his 2001 to 2004 tax returns together in 2006, claiming business losses due to online trading. These losses were denied, and thus the appeal to the court.

Though trades occurred on only 5-10% of the available trading days, there was a discernible strategy for identifying highly volatile shares trading in high volume, and trades ensued therefrom. At one point, Mr. Zsebok even dipped into his RRSP account to fund his non-registered margin account, exacerbating the losses with the fact that he had to pay tax on those withdrawals.

At points the judge viewed the activities as “feverish”, “foolishly” undertaken, and in pursuit of “get rich quick dreams”, though in the end unsuccessful. Despite these impressions and misgivings about the late-filed returns, the issue before the court was whether the actions constituted an adventure in the nature of trade. On this point, the taxpayer won on 3 of the 4 years’ assessments.

Mittal v. The Queen, 2012 TCC 417

Reproduced in this judgment is a nine-part business plan that includes personal development goals, buy and sell rules, monetary and time commitments, and even a contingency plan: “Take one week off from the markets to reevaluate my trading, current market conditions, my risk management and my mental and emotional stability. If a vacation is necessary, take one.”

The business plan guided the investing activities of Mr. Mittal, a retired engineer and self-described workaholic. In the judge’s view, this was an organized and businesslike approach to investing, though ultimately leading to losses of almost $70,000 over two taxation years.

The combination of a well-documented plan and carefully tracked activities contributed to the judge’s ruling that there was a clear intention to conduct business activity, despite the lack of success. Together with the favourable findings on the other factors, Mr. Mittal was entitled to his deductions.

Practice points

Understanding the five factors will help a taxpayer decide whether it is worth the cost and aggravation to appeal an assessment.
The act of good recordkeeping can be strong evidence of a taxpayer’s intentions, on top of the obvious benefit of quantifying claims.
The implication of successfully claiming a deduction would likely be that trading gains would be fully taxable, rather than one-half treatment of capital gains. Accordingly, would-be claimants should obtain tax advice before taking a position, as this could have lifelong repercussions.

Deductibility of investment fees, MERs – Six of one, half-dozen of the other?

With the growing number of exchange-traded funds (ETFs) in the market, the media has been abuzz with discussions about the cost of obtaining investment advice.

While mutual fund management expense ratios (MERs) are designed to incorporate the cost and compensation for an advisor’s professional expertise, ETFs do not include such charges, being more commonly recommended within a fee-based program.

Such programs often tout the tax-deductible nature of their fees, but are they really all that different from the net tax treatment of mutual fund MERs?

Basis for deductibility

While a qualified professional may indeed be providing valuable financial guidance, that in itself is not sufficient to result in deductibility.

In order for investment counsel fees to be deductible, the Income Tax Act requires that such fees are for advice regarding the purchase or sale of specific shares or securities, or for services in respect of the administration or management of shares or securities. Furthermore, the fees must be paid to someone whose principal business is to advise or provide service in such investment matters.

Assuming that the nature of the advice and amount charged for it will be the same whether within an MER or as a separately levied amount in a fee-based program, are the after-tax results any different?

We can use a simplified example* of a 5% interest return where the total cost to the investor will be 2%, either as an MER or as part of an advisor’s fee-based program.

$10,000 invested Mutual fund Fee-based program

Interest income $500 $500

Less: MER $200 0

T3 slip income $300 $500

Less: Investment counsel fee 0 $200

Taxable income reported $300 $300

*Note: A more detailed example is illustrated in our InfoPage “Deductibility of investment fees”

As shown, the investor ends up with the same taxable income by either route. Whereas the mutual fund reports the net amount, the fee-based program gives the investor the opportunity and obligation to actually claim the deduction when preparing the year’s tax return. It is perhaps this active step of claiming the deduction that leads some to the misconception that only those latter fees are tax-deductible.

What is not deductible?

In order for fees to be deductible, the Canada Revenue Agency requires that the amounts claimed must be reasonable; this requirement will normally be met if the fees are paid to an unrelated person. Where the payment is to a related person, there may be closer scrutiny on type of activity and time spent.

Deductibility does not extend to general financial counseling or planning, even though it is carried out by a professional who can legitimately levy investment counsel fees.

Finally, as might be expected, neither MERs nor separate fees are deductible when associated with an RRSP or RRIF. An investor may, however, choose to pay those separate fees from outside the RRSP or RRIF, thereby preserving those tax-sheltered assets even if only to a modest extent.

Note: For Quebec provincial taxes, deductions can only be taken against income earned. For more details, see our InfoPage “Deductibility of investment fees”.

Practical applications of corporate class mutual funds

Corporate class mutual funds have unique features that make them stand out from other investment options. Chief among the tax benefits of these features are the:

Ability to rebalance holdings within the corporation without triggering dispositions, due to the exchangeability of share classes at adjusted cost base; and
Expectation of lower current distributions, due to the netting of gains and losses across share classes under consolidated corporate accounting.

While these are key details for an advisor’s knowledge, seldom does a client explicitly request benefits or features, let alone ask for an asset class or particular product. Rather, clients view financial advisors as problem solvers: the client has a current concern or future expectation and looks to the advisor to resolve the issue or at the very least suggest options that assist in moving toward a satisfactory resolution.

With that in mind here are a few situations where an advisor may have the opportunity to discuss the merits of corporate class funds as an addition, alternative or complement to a client’s current condition or investment approach.

Personal annuities

An annuity can provide guaranteed lifetime income, the price being the commitment of a lump sum of capital. You can also purchase a guarantee in case you die early. So what’s the cost of betting against yourself on both ends?

It may provide a reality check to compare the annuity income against the drawdown of a continuing managed portfolio. In the RRSP world, a person can hedge expectations by allocating between the security of a registered annuity and the flexibility of a RRIF. Either way, all eventual flows are fully taxable.

For non-registered funds, the taxes are a little more complicated. Generally for personal annuities, each payment is a fixed proportion of non-taxable capital and fully taxable interest. By comparison, a systematic withdrawal out of a corporate class mutual fund yields both non-taxable capital and one-half taxable capital gains, with the taxable portion increasing over the years.

Using reasonable return assumptions, a comparison of those annuity flows against the projected draw from the mutual fund corporation can provide some context for the cost of those guarantees. Whether or not this review changes a client’s course, this type of analysis will assure a more fully informed decision.

Managing foreign dividends

In an article earlier this year (Fundamentals, March 2011: “Is home bias simply rational self-interest?”), I adverted to the interaction between foreign dividends and corporate class funds. I have had a few advisor conversations on the topic since then and thought this would be an appropriate place to flesh out those earlier comments.

Foreign dividends are treated as regular income, which from an investment perspective is the same rate applied to interest. Accordingly, a top-tax-bracket investor receiving foreign dividends faces a tax rate of nearly double the rate applicable to Canadian eligible dividends. The rate disparity is even more pronounced at lower brackets once the two-stage mechanics of the gross-up and tax credit procedure are applied.

Another possibility is for an investor to hold foreign interests through shares of a Canadian mutual fund corporation. Foreign dividends are income to the corporation itself, and the corporation can apply its expenses against that income to reduce its potential to pay taxes. The investor thus expects capital appreciation, with only one-half of eventual capital gains then being taxable.

Passive investments within private corporations

Private corporations may be entitled to a low tax rate on active business income, but passive investment income is subject to the full corporate rate plus a penalty tax. With their tax-deferral benefits and low distribution expectations, mutual fund corporation shares would be an ideal consideration for private corporations.

In terms of accessing the funds, a T-series overlay could be used to receive a greater amount of non-taxable return of capital in early years, deferring capital gains until later.

As corporations face flat taxation – as opposed to the graduated bracket treatment of individuals – the tax-deferral opportunity can therefore be particularly effective in the private corporation context.

For some numerical support on these examples and discussion of other practical uses of corporate class shares, you can view the replay of our recent webcast on the topic – and obtain continuing education credit in the process.