Module 6: Capital gains and losses - PD Net

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Capital losses on personal-use properties are not deductible or, in the case of listed personal properties, can only be claimed against capital gains realized on other listed personal properties. Capital losses on some transactions specified in the ITA are not deductible, or their deductibility is deferred until a specific event occurs. The reasons justifying the special treatment of capital gains may be summarized as follows: The preferential treatment of capital gains promotes investment, particularly in risky ventures, by giving the investor a potentially higher yield on investment. The gain realized on property that is held for some years is caused mainly by inflation. To adjust the gain to take into account the inflation component would be very complex. It is better, in terms of certainty and simplicity, to have a universal rule such as the one-half inclusion rule. However, this general rule applies whether property is held for many years or only for a few months. In the case of short-term capital gains, the reduced rate of inclusion causes inequity between taxpayers who realize capital gains that are only one-half taxable and taxpayers who earn other types of income. Capital gains are taxed when realized, and not on an accrual basis. This is because of the difficulty that taxpayers, as well as the tax authorities, would have in valuing all capital properties annually in order to determine accrued capital gains. Also, taxing capital gains on an accrual basis could create financial problems for taxpayers who would have to pay taxes when they have not yet cashed in their gains. However, the taxation of capital gains when realized means that the accumulated gain is taxed in the year of disposition and may be taxed at a higher marginal tax rate for individuals than it would have been taxed if recognized as it accrued. The principal residence exemption stems from a presumption that no real economic gain is realized when a home is sold and another is purchased. While this could apply to capital gains on other personal-use property, the government has chosen to exempt gains on a taxpayer's principal residence only. But even when a new home is not purchased and there is no economic reason not to tax the gain as any other gain, it is a widely-accepted proposition that the gain from the sale of a home should not be taxed. The idea that home ownership must be supported because it promotes community stability is the basis for this principle. The capital gains deduction (section 110.6) on small business corporation shares, farm property or fishing property was introduced to encourage entrepreneurial risk taking and to support investments in these businesses by Canadians. Over the years, these reasons were often criticized on the basis that the preferential treatment infringes on horizontal and vertical equity. Horizontal equity requires taxpayers who have similar economic power to bear the same tax burden. From an economic point of view, there is no reason for a different tax treatment of a dollar earned as salary and a dollar derived from a capital gain. Vertical equity requires that taxpayers who have a higher ability to pay tax are taxed more than those with a lower ability to pay. Since mostly high-income taxpayers derive capital gains, they are the ones who benefit from the preferential treatment of capital gains, and thus, vertical equity is affected. The preferential treatment is also criticized on the grounds that it invites tax avoidance schemes. Taxpayers may try to devise transactions to transform income from a source into capital gains. Complex anti-avoidance rules are therefore needed. This adds to the complexity of the ITA and imposes administrative costs to the government to ensure compliance with these rules. These costs are supported by all taxpayers and not only by those involved in the transactions under scrutiny. It has also been suggested that the preferential treatment of capital gains may be a disincentive to use resources in the most productive way. Since capital gains are taxed only when realized, taxpayers can control the timing of the recognition of these gains. Taxpayers may be reluctant to sell property and pay tax when file:///F|/Courses/2010-11/CGA/TX1/06course/m06t01.htm[11/10/2010 4:41:57 PM]
substantial gains have accrued on the property, even though more productive investments are available. As you can see, the tax treatment of capital gains is controversial. The government has chosen to consider capital gains and losses as a special type of income for tax purposes for the reasons outlined earlier. Whether or not these reasons are valid in the present context is subject to debate. Nonetheless, taxpayers have to abide by the rules contained in the ITA. The tax treatment of capital gains is also complex because, for policy reasons, the tax rules vary, depending on the type of capital property that is disposed. Keeping in mind the preceding comments on the tax policy behind the ITA rules concerning capital gains and losses, you will now study these rules. file:///F|/Courses/2010-11/CGA/TX1/06course/m06t01.htm[11/10/2010 4:41:57 PM]
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Module 6: Capital gains and losses - PD Net

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