Losses – 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.

Of horse breeding, tax losses and RRSPs

“The very term “Arabian horses” takes me back to the early 1960s watching in awe as Lawrence gallantly galloped across the Arabian sands on a sinewy strong stallion. The power, the grace, the beauty – it was unforgettable.”

So begins the judgment in the case of Teelucksingh and the Queen. It seems almost a shame to bring this eloquent prose back to the ground by bringing up taxes, but that is what it was all about after all.

It’s a horse race that has spanned 18 years since first assessment – and 11 days in court – and at the pole the taxpayer appears to have nosed out the Queen.

The plan is conceived

The genesis of the tax plan was the financing of a herd of Straight Egyptian Arabian horses. In order to build a sufficiently sized herd to be a viable business venture, Montebello Farms needed to gather cash. It struck upon the idea of pooling disparate investor funds through the use of a limited partnership structure.

Using example numbers detailed in the judgment, the key events in the arrangement were as follows:

Under an Offering Memorandum, an investor borrowed $18,000 from Montebello, to acquire a limited partnership interest and common shares in a corporation
At closing, current and prepaid expenses (including horse inventory) led to a farming loss distributed at $9,520 per unit, some useable that year and the rest carried forward
Following closing, the partnership transferred the assets to the corporation in exchange for preferred shares, which shares were distributed to the limited partners about 45 days later upon planned dissolution of the partnership
The preferred shares were structured to qualify for deposit to the investor’s RRSP, which at purported fair market value allowed for a swap-out of $18,236 in cash, the bulk of which was then used to retire the Montebello loan
Dividend payments of $45,000 were made in each of the two following years, after which the corporation was dissolved

A bump in the road

Mr. Teelucksingh was one of hundreds of Montebello investors reassessed by Canada Revenue Agency (CRA). He participated in two Offerings, commencing in 1993 and 1995 respectively. In 2001, he was reassessed, with the restricted farm losses being denied and the RRSP transactions being treated as taxable withdrawals.

On appeal at the Tax Court of Canada, the judge summarizes the horse operations, but otherwise makes it clear that the case “is about the tax consequences of the investing arrangement more than about the intricacies and complexities of the horse business.”

The result would turn on the legitimacy of the partnerships, the valuation of the horses, and the reasonableness of two years’ prepayment of expenses.

Down to the wire

Interestingly, the judge did not find fault with the bona fides of the partnership nor with the complex series of transactions, expressing his only reservation to be “the inflated value of the horses.” Caught between optimistic and pessimistic expert testimony on either side of the dispute, the judge arrives at a compromise valuation for the horses at something less than half of the original values.

As to the prepayment, he stated, “While I have some concern as to the commercial reasonableness of such a prepayment provision, I have nothing concrete upon which to substitute my judgment for the partnerships’ judgment.”

Thus, almost two decades after supporting the herd, Mr. Teelucksingh will enjoy both the farming losses and RRSP gains, though not as lucratively as initially projected.

Time to pull the trigger? Making use of capital losses

In the midst of the current market turmoil you’ve continued to counsel your clients to stay invested for the long term because even these conditions will eventually pass.

Still you know, market downturns can provide planning opportunities to take advantage of losses and offset other capital gains.

As a result of fund distributions due to internal rebalancing or your client’s own decision to dispose of some investments, capital gains may have been realized in the current year. Those gains could be neutralized by making dispositions designed to crystallize sufficient offsetting capital losses, with any excess carried back to recover capital gains related taxes paid in the last three years, or perhaps set the stage to carry forward in anticipation of future gains.

But what happened to staying invested for the long term? So long as the business fundamentals underlying your portfolio construction remain valid, these broader market movements should not completely invalidate well considered past choices.

If you re-acquire those same funds within 30 days though, those capital losses cannot offset the gains due to the superficial loss rules. Particularly with the wild market swings we’ve experienced, stepping out of the market for 24 hours – let alone 30 days – may mean missing a large part of the recovery.

Part of the answer may be to employ fund switches not exposed to the superficial loss rules. Specifically, if you are disposing of mutual fund trust units, you could immediately acquire shares of a mutual fund corporation with the same or similar holdings. And it works the other way too if you want to dispose of fund shares to acquire fund units.

By the way, be ready to counsel your clients on what to do with the newfound cash recovered from those past paid taxes.