Canada: Transfer Capital Losses
Take Advantage of Tax Act Provisions to Reduce Household Tax Payable
Oct 16, 2008
Many Canadians may be ending 2008 with capital losses in their non-registered investment portfolios. While the Income Tax Act does not specifically set out this process, it is possible to arrange your affairs to transfer a capital loss over to your spouse.
Who Can Use This Strategy?
This strategy is useful when one spouse is about to realize a capital loss but has no capital gains, either in the current year or any of the three previous years, to offset the loss, but the other spouse has capital gains in one of these years.
Affiliated Persons and Superficial Losses
The Income Tax Act provides that spouses are "affiliated persons" for tax purposes. This means that the special rules apply when a loss is realized on the transfer of property from one spouse to another.
When losses are transferred between affiliated persons, the loss must be categorized as a "superficial loss" as defined in the Income Tax Act. A superficial loss arises when one affiliated person acquires identical property within a period that starts 30 days before the transfer, and ends 30 days after the transfer. A superficial loss is defined to be nil.
Transfers at Fair Market Value
It is possible to elect to have the transfer between spouses happen at fair market value. If you make this election, the loss arising on the transfer will be realized, but the loss will still be superficial.
At the same time, any capital loss realized on transferred property will attribute back to the transferor spouse as an affiliated person.
The way around the attribution rules on the transferred property - to avoid having the loss attributed back to the transferor spouse - is to have the transferee spouse pay fair market value for the property.
Real-life Example: Sharon and Jonah
Taken together, these provisions provide a strategy for transferring capital losses between spouses. Here's how this might work in real life:
Sharon has an unregistered investment account which holds marketable securities with an unrealized loss of $25,000. She bought them five years ago for $50,000. She has no unused capital gains on other property, including in the three years since she acquired the securities in question. However, her husband Jonah has $50,000 in unrealized capital gains.
Transfer in Exchange for Promissory Note
To use the tax loss transfer strategy outlined in this article, Sharon transfers the securities to her husband in return for a promissory note in the amount of $25,000, which is the fair market value of the securities.
Normally, this transfer would be deemed to have taken place at $50,000, which is the adjusted cost base (the cost for tax purposes) of the securities. However, Sharon elects to report the transfer at fair market value. Accordingly, she accounts for the transfer at fair market value on her tax return, and realizes a capital loss of $25,000.
Adjust Loss to Nil
The loss that she realizes is a superficial loss. Therefore, although she reports the loss on her tax return, she adjusts the loss to nil, noting that it is a superficial loss. That is, Sharon doesn't claim the capital loss on her tax return.
Adjusted Cost Base of Transferred Shares
The cost of the shares to Sharon's husband is the $25,000 that he paid. The adjusted cost base of the shares, however, is $50,000.
Promissory Note Bears Interest
Because Sharon and her husband do not wish to have the attribution rules apply, the promissory note Sharon takes back from her husband is interest-bearing, at the prescribed rate.
Sharon and Jonah calculate interest on the note as long as it is outstanding, and Jonah pays Sharon the interest due before January 30 of the year following the year of the transfer.
Hold Transferred Shares for 30 Days or More
Jonah holds the transferred shares for at least 30 days, so that the loss he realizes when he disposes of them is not treated as a superficial loss. He then sells the both the shares he acquired from Sharon, and the property that gives rise to the capital gain.
He can now deduct the allowable loss on the shares he acquired from Sharon, which is $12,500, against the taxable gain on his own shares.
Consult Your Tax Advisor
This strategy can be an effective way to optimize the Canadian tax situation between spouses with unrealized capital gains and losses. Consult your tax advisor to see if your situation allows you to take advantage of a transferred tax loss!
