DAVID WILKENFELD, CPA, CA, canadian tax CONSULTANT

Capital vs. Income: The Never-Ending Question

In Canadian Income Tax, Capital vs. Income on March 15, 2010 at 5:27 pm

“You’ve got so much to say
Say what you mean
Mean what you’re thinking
And think anything…
Why not?”

The capital gains vs. income debate has been around since the days when Cat Stevens was…  well, Cat Stevens. When an asset is sold, there is often a question as to whether it was originally purchased as a capital investment, or with a view solely to making a profit from its resale. If it is the latter, the gain or loss is considered an “adventure in the nature of trade” and is taxed on income account. Capital gains are taxed at half the rate of other income so this is always a hot topic.

This issue will normally boil down to the specific set of facts, which makes it fertile ground for court disputes. The general rule is that, if the asset was acquired originally as a long-term investment, the gain on the sale is on capital account. The way in which the asset was used or its intended use while it was owned becomes the overriding factor..

In the case of Happy Valley Farms, the Federal Court set out a number of factors that must be analyzed in determining whether a gain is of an income or capital nature. These include:

1. The nature of the property sold. Property generally useful in a business or for the personal enjoyment of a taxpayer would be more likely to be viewed as being acquired as a capital asset. Property that does not yield some long-term benefit is more likely to have been acquired for the purpose of resale.

2. The length of period of ownership. Generally, property meant to be resold is realized within a short period of time after acquisition. Nevertheless, there are many exceptions to this general rule.

3. The frequency of other similar transactions by the taxpayer. If the same sort of property is sold frequently, the presumption arises that it is being purchased and sold for profit.

4. Work expended in connection with the property. If effort is put into attracting purchasers, or increasing the marketability of the asset, there is evidence of dealing in the property.

5. The circumstances responsible for the sale. There may exist some explanation, such as an unforeseen event that forced a sale prior to the time originally intended at the time of purchase.

6. Motive. The intention at the time of acquiring the asset as inferred from surrounding circumstances and direct evidence is one of the most important elements in determining whether a gain is of a capital or income nature.

While all of the above factors have been considered by the courts, it is the last one, the question of motive or intention, supported by the taxpayer’s course of conduct, which has the most influence. Uncertainty arises because no tax assessor or judge can ever know for sure what a person is thinking. The courts, therefore, look to the specific set of facts surrounding the issue, and the actions of the taxpayer to try to discern this intent.

Secondary Intention

The concept of “secondary intention” has been one of the most troublesome for taxpayers and judges over the years. If the court determines that a taxpayer’s intention was to purchase a property for capital purposes, it may go a step further, to analyze the secondary intention. That is, did the taxpayer have in his mind a secondary intention to profit from the sale of the asset as another of his motives when making the purchase? This difficult concept was explained in the case of Racine et al as follows:

…the fact alone that a person buying a property with the aim of using it as capital could be induced to resell it if a sufficiently high price were offered to him, is not sufficient to change an acquisition of capital into an adventure in the nature of trade. In fact, this is not what must be understood by a “secondary intention” if one wants to utilize this term.

To give to a transaction which involves the acquisition of capital the double character of also being at the same time an adventure in the nature of trade, the purchaser must have in his mind, at the moment of the purchase, the possibility of reselling as an operating motivation for the acquisition; that is to say that he must have had in mind that upon a certain type of circumstances (sic) arising he had hopes of being able to resell it at a profit instead of using the thing purchased for purposes of capital.

As long as there exists a gap in the tax rates between income and capital gains, these concepts will be relevant any time there is a dispute with the CRA

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