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Tax Planning in a Downturn

By: David Louis,  J.D., C.A., Tax Partner.
Minden Gross LLP, a member of MERITAS Law Firms Worldwide.

(*This release is based on an article published in Tax Notes # 550, November 2008, CCH Canadian Limited)

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I am tempted to pontificate on how so many financial advisors are too young to remember the “crash” of ’87, let alone something really serious.  I could query how it came to be that mutual funds replaced savings accounts; how people came to believe that the market goes in only one direction, or how US politicians have regressed to Herbert Hoover’s laissez faire policies[1].  But my job is just to give tax advice.  So I will confine my comments to some thoughts in respect of tax planning in a downturn.

Tax Loss Selling

Of course, given the time of year, the first thing that comes to mind is tax-loss selling.  Alas, this could turn out to be of critical importance, as a tax refund from a loss carryback may be a valuable source of cash for a business, or just to meet day-to-day living expenses. 

In most cases, stock market losses and the like will be capital losses[2].  Capital losses realized in 2008 must be claimed against capital gains realized in the same year.  A three-year carryback is available on an elective basis; otherwise, unutilized capital gains can be carried forward indefinitely.  In the past, I have said that if you do not have capital gains this year or in the previous three years, there may be no point in triggering the loss.  However, with the extraordinary declines that have taken place in recent weeks, depending on the particular circumstances, consideration might be given to triggering large loss positions to be “warehoused” for future gains, i.e., on the assumption that (hopefully) we will never again see things this low.

However, if an individual wants to buy back in, he or she should be aware of the superficial loss rules.  These rules will be operative if the individual or an affiliated person (see below) buys an identical investment in the period within thirty days before or after the tax-loss sale, and continues to hold the investment[3] at the end of the period.  Once upon a time, the standard strategy would be to wait thirty days before buying back in.  But the way things are going these days, the markets could be up (or down) a thousand points in a few hours, let alone thirty days.  So the better thing to do could be to have a non-affiliated person buy back in.  While an affiliated person includes a spouse/common-law partner or controlled corporation, children are not affiliated with a parent, nor would a parent be affiliated with a family trust if neither of the parents are beneficiaries.  For years, it used to be the case that the superficial loss rules would not apply if the individual’s RRSP were to reacquire the same investment; however, the 2004 budget put an end to this.

Rather than paying brokerage fees if you sell in the market and an unaffiliated person buys back in, it may be possible to trigger the loss by transferring the securities directly to the non-affiliated transferee.  However, assuming that this is evidenced by switching the security to the transferee’s brokerage account (based on its value at the time of the transfer)[4], you may have to contend with the universal market integrity rules, which restrict off-marketplace transfers of securities[5].  It is my understanding, however, that a gift is exempt from these rules, but you should consult your broker[6].  Also, if the transfer is not a gift, the transfer price should generally be at the fair market value of the particular security.[7] 

To trigger a 2008 loss, the trade must settle by December 31st.  On Canadian exchanges, the last day you can trigger a tax loss in 2008 is December 24th.  Before realizing a capital loss in a corporation, one should review whether it has a positive capital dividend account from previous capital gains.  If so, a capital dividend should be declared beforehand, as the capital loss will reduce the capital dividend account and therefore the ability to pay tax-free dividends to shareholders.

But where are the Gains?

Alas, the biggest question may be whether you have gains to shelter.  Investors should not overlook longstanding holdings of BCE, the takeover of which is expected to close in December – if, of course, all goes well.  But there are two other questions.  First, do you really have a capital loss?  While many investors think that they have sustained huge losses in recent weeks, it often turns out that these are paper losses only – they are giving back the accrued gains from recent years, rather than suffering an absolute loss relative to the actual tax cost of the particular investment.  In determining whether a taxpayer has losses, this must be done on an investment-by-investment basis.  Another thing to bear in mind is that, if there were several purchases of the same investment, the tax cost is calculated on a weighted average basis – even if the shares were held in different brokerage accounts.  But the cost base averaging rule applies only to identical investments beneficially owned by the particular taxpayer. 

If you are trying to shelter a gain, whose gain are you sheltering?  Very often, the spouse with the gains may not be the one with the losses.  If this is the case, one strategy that may come in handy is the “superficial loss shuffle”, which, as the phrase implies, allows tax losses to be shuffled between spouses.  The idea is that, if the loss investment is transferred to the spouse with the gains at fair market value (e.g., for cash or a promissory note bearing interest at the CRA’s prescribed rate – currently 3%), the loss can likewise be transferred to the spouse, provided that the spouses elect out of the rollover in subsection 73(1) of the Income Tax Act.  Alternatively, the spouse with the losses can simply sell the loss investment, with an identical investment bought by the spouse with the gains (with his or her own funds) within 30 days of the sale.  Under these circumstances, the accrued loss at the time of the other spouse’s transfer or sale will be added to the cost base of the loss investment now held by the spouse with the gains and the loss[8] on its eventual sale will be claimed by that spouse.  This strategy has been affirmed by the CRA[9].  However, to trigger the superficial loss shuffle, the loss investment must be held by the spouse with the gains at the end of the 30 day period after the sale or transfer by the spouse with the losses.  As I said, given the twists and turns in the market, this requirement might involve significant uncertainties.  

Another possibility for tax-loss selling could be a recently-acquired real estate investment.  As I pointed out a year ago[10], this could be a US investment, especially since this market is even worse than it was last year - and still shows little sign of bottoming-out.  However, a gain or loss must be measured in Canadian dollars; so recent appreciation of the greenback against the Canadian dollar may reduce the loss.

For Ontario real estate at least, land transfer tax may also be a significant consideration, although in some cases, tax losses could be triggered without land transfer tax applying.[11]  In the real estate recession of the 90s, properties were so far underwater that land transfer taxes were modest in relation to the income tax saving.  This time around, we may not be there – not yet, anyway.  So land transfer tax could blow out the income tax benefits, especially if the land is located in Toronto, where the tax can top out at 4% for residential properties (3% otherwise).

Other Tax Planning

If the bad economy continues, there will be many other tax planning areas that may be relevant.

For example, a downturn may be an opportune time to undertake an estate freeze or other estate planning.  If an estate freeze has previously been done at a higher value, it is possible to “refreeze” at a lower value.

Some defensive tax planning may also be in order.  In recent years, the CRA has enhanced its powers to go against taxpayers, and you can bet that the CRA will make full use of them.  One of the biggest lines of attack will be based on joint and several liability for unpaid income tax, to the extent that assets have been shuffled to a non-arm’s length transferee for less than full consideration.[12]  This includes dividends received from a closely held company – and there is no assessment limitation period pertaining to the transferee.  Careful consideration should be given to structuring distributions and transfers in a way that minimizes the risk of a successful CRA attack.  Another area for CRA attack is directors’ liability for unpaid source deductions and GST.  Again, there is no assessment limitation period, other than a two-year limitation period that applies once a director has resigned.

Default procedures can have greatly differing tax effects to a debtor.  Creative tax planning can minimize adverse tax effects (e.g., in respect of debt forgiveness, foreclosure versus power of sale, etc.).  Similarly, workouts and other insolvency-type transactions can be structured to maximize preservation of losses and tax pools, perhaps allowing these to be monetized to enhance recoveries for creditors.

— David Louis, J.D., C.A., Minden Gross, Toronto, a member of MERITAS law firms worldwide.