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Taxation dilemma


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Well unfortunately, I am looking into this again. The issue is about business income vs capital gains or something found in IT-479R of the Canadian Revenue Agency. I am wondering if there is something similar in the U.S. as well:

 

 

"11. Some of the factors to be considered in ascertaining whether the taxpayer's course of conduct indicates the carrying on of a business are as follows:

 

(a) frequency of transactions - a history of extensive buying and selling of securities or of a quick turnover of properties,

 

(b) period of ownership - securities are usually owned only for a short period of time,

 

© knowledge of securities markets - the taxpayer has some knowledge of or experience in the securities markets,

 

(d) security transactions form a part of a taxpayer's ordinary business,

 

(e) time spent - a substantial part of the taxpayer's time is spent studying the securities markets and investigating potential purchases,

 

(f) financing - security purchases are financed primarily on margin or by some other form of debt,

 

(g) advertising - the taxpayer has advertised or otherwise made it known that he is willing to purchase securities, and

 

(h) in the case of shares, their nature - normally speculative in nature or of a non-dividend type.

 

12. Although none of the individual factors in 11 above may be sufficient to characterize the activities of a taxpayer as a business, the combination of a number of those factors may well be sufficient for that purpose. Further, subsection 248(1) defines the term "business" to include "an adventure or concern in the nature of trade" and the courts have held that "an adventure or concern in the nature of trade" can include an isolated transaction in shares where the "course of conduct" and "intention" clearly indicate it to be such."

 

 

Basically, I am currently unemployed or retired if you will. I have sold a small business in 2011 and now I only have investment income as source of income. Needless to say, and I believe it is the case for the majority out here, overtime the bulk of investment income has come in the form of capital gains. Currently, I would only be able to cover a portion of my annual living expenses with dividends and interest (negligible). It is rare that I find very undervalued stocks paying meaningful dividends and bonds other than t-bills generally never appear in my portfolio. So I do rely on my investment appreciating to live on and if they are not, I will use the capital.

 

If one reads carefully the IT bulletin from the CRA, I wonder how many on this board would qualify for capital gains treatment or considering that most would fit under C), D) and E) and many partially under B), F) and H).

 

Basically, this is how I interpret the rules: if you are booking each year large capital gains and it forms a good portion of your income, your stocks pay no or little dividend, you know a thing or two about stocks and buy them based on sound analysis, then you should not be eligible for capital gains treatment. If you manage an investment partnership as some do here, I really don't know how you can avoid business income treatment even for your own stake in the partnership.

 

The defense could sound like this: the holding period on average is relatively long (a year or more), security purchases are financed primarily with cash, there is no advertising about trading in securities.

 

Reading the bulletin, I don't even know if having a job or a business means much to the CRA once your investment income, again coming mainly from capital gains, starts to exceed your other sources of revenue. Or if your returns are well above average (15% and more a year) and derived by your activities.

 

So before I contact an expensive attorney specialized in taxes to study previous cases and figure out my options, I wonder if any of you has been involved in a tax audit with this issue having come up. Or, what have you done already to avoid the issue to arise in the future?

 

Of course, one could go on and ignore the issue until the CRA shows up, but then they could decide it is business income, charge you for unpaid taxes, assess penalties plus interest and who knows how many years back they could go. The total amount due could turn out to be enormous. The rule is so unclear it is sickening.

 

Many thanks in advance

Cardboard

 

 

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If you manage an investment partnership as some do here, I really don't know how you can avoid business income treatment even for your own stake in the partnership.

 

Not that big an expert regarding your situation but regarding this comment above, in the US, one of the most outrageous acts of highway robbery committed against the general public was introduced and still prevails under the concept of "carried interest", which allows money managers to pay capital gains taxes on their earned income.

 

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I think that you are a bit overzealous on this.

 

(a) frequency of transactions - a history of extensive buying and selling of securities or of a quick turnover of properties,

Not likely to happen if you are a value investor

 

© knowledge of securities markets - the taxpayer has some knowledge of or experience in the securities markets

If you don't have a CFA or a real diploma it's practically unprovable that you know much about securities.

 

(d) security transactions form a part of a taxpayer's ordinary business,

Define ordinary... is 1 hour a day a business or a hobby? How can anyone prove that you spend more then 1 hour a day on reading 10-k?

 

(e) time spent - a substantial part of the taxpayer's time is spent studying the securities markets and investigating potential purchases

Again. Unprovable.

 

My point is that it would be impossible for the CRA to prosecute you. You could have compounded your money at 15% per year by pure luck. After all, that's what the random walk theory is all about right...

 

BeerBaron

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Cardboard, I agree with Beerbaron.  It would ultimately be up to the CRA to prove you are running a business and not just living off your investments while you look for work.  The only thing they can really see is your trading records.  I think your worrying excessively about getting a fine.  I would be inclined to let them figure it out and prove it.  I get mini-audits every year - requests for info which I fulfill.  Never have I been approached about running a business even though in the past 3 years (prior to 2011) my investment gains exceeded my work earnings. 

 

In the meantime you may want to keep a record of all of those investment related expenses such as your phone, internet, car, gas usage, residential (office) expenses.  When the day comes, if it does, you can write all of these things off as business.  Even travel could be written off - dropped into Aapl store in Madrid.  The easiest way to keep track of all of the above is to dedicate one bank account, credit, or debit, and print out and itemize it once per year. 

 

As an aside I have toyed with turning part of my investments into a business in order to write off assorted expenses.  So far it does not appear worthwhile.  I will probably contact a good tax accountant when that day arrives. 

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Thanks guys for the responses, that is encouraging! You bring up good points.

 

Not being a lawyer, I simply hate this type of language that the CRA is using. The whole bulletin is a mess. Even short sales of Canadian securities can be counted as capital gains if you file the T123 election. And if you read further, then the election is more or less meaningless since it is kind of applicable by default. Same for stock options (both buying and writing) that can be treated as capital gains if you are consistent from year to year.  ???

 

The problem is that this is the law and you have to follow it. However, you just don't know what to follow! That is why I would still be curious to find out about someone who went through this ordeal or a Court case of Canada vs some individual.

 

It is true that they have to prove it, but I think that it should be pretty easy. By simply having the Court demanding you to submit your PC and IP address, they could find out how much time you spent on various sites and see Excel, Word files and other documents that you have downloaded. CRA agents could also ask a few of your neighboors and friends to find out what you are doing during the day. Well, maybe that I have watched too many episodes of 24!

 

Anyhow, this whole thing reminds me that I should stay way from stressful things such as stock options and margin debt and to stick with plain vanilla fully paid for value stocks. Also, that I should find another venture since you truly can't spend all day looking over your stocks and new ones without going nuts. Most of the time, there is simply not much to do. You have to let things work themselves out and by simply doing that, you probably meet the spirit of the law.

 

Cardboard

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Getting at your personal property requires a search warrant.  I am skeptical that any normal level CRA Auditors have the skills to do this.  So, they would need to bring in a special investigation team.

BTW - I have some 'real life' experience with search warrants - obtaining them, not being subject to.

 

Do you really think your worth the effort, on a cost benefit analysis for the CRA?  If it ever came to it, you hire a tax lawyer, or just pay them the taxes they want, which is likely cheaper than the lawyer.

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I spend time around investing subjects for entertainment purposes, it does not necessarily involve actions on my portfolio. I find it very hard to believe that gaining "knowledge" alone, for fun or potential profit can be used against you in this way. And that's the point, it's a conjunction of factors, not just one. Just buying a stock for long-term holding on margin is unlikely to trigger this distinction either.

 

Just buy insurance...obviously transaction volume is most likely the largest input, so trade less and when you want to sell part of a stock, don't sell it in little lots over several days, just sell all that you want to sell in one transaction.

 

Go to financialwebring.org, they discuss this topic extensively in the message boards, you can do a search.

 

You can fill out form T-123 and PRE-CLAIM all your security transactions on account of Capital instead of Income IF the securities are Canadian! No such benefit for trading in US stocks.

 

This analysis of a tax case may be instructive of the thought process, there are many cases on tax court of canada website: http://www.deloitte.com/view/en_US/us/Industries/Private-Equity-Hedge-Funds-Mutual-Funds-Financial-Services/c1d38d52c7171310VgnVCM1000001a56f00aRCRD.htm . Notice in this case, the person was classified as capital gains instead of a trader.

 

You can see that the criteria for trader status is quite high. I mean, in my book this guy was definitely a trader, but not for CRA! I think for all intents and purposes, only a day trader would fall under the business income rule. I mean all you have to do is not buy and sell the same stock on the same day and hold if for 30 days or longer. Not hard to meet this criteria at all.

 

 

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Scorpioncapital,

 

The case you mentioned seems like a U.S. one since there is the mention IRS. I checked on the Deloitte Canadian site and did not find one specifically about the CRA and this issue.

 

By the way, did you file that T-123? What is the purpose of it since I have always filed my taxes using capital gain treatment for securities and never heard a thing from CRA about needing this? Also, if they declare you a "trader" or subject to what I have described, then what is that election doing for you?

 

Cardboard

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I've read dozens of cases on the tax canada website a year ago regarding this issue and the US judgement seems almost identical to the Canadian cases in terms of criteria. The biggest red flags are trading the same stock on the same day, or trading in and out of it within 30 days on a relatively large scale. The whole issue is also complicated by superficial loss rules, if you sell a stock within 30 days and buy it back, you are deemed not to have a loss and add the loss to the cost basis of the stock - for capital gains treatment in the future!

 

Regarding T-123, view: http://www.cra-arc.gc.ca/E/pub/tp/it479r/it479r-e.txt , it explicitly states that if you elect this method, you will get capital gains treatment even if you are a trader. This is a benefit Canada gives to Canadian security investors vs. foreign. Another reason to own Canadian stocks if you trade in and out frequently.

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Two comments

 

1/ Who said CRA has to prove their case in order to fine you and re-assess you?  Generally, CRA re-assesses, fines you, etc., and once you pay it, then you can appeal it.  If you don't pay it, your fines and interest will build if you are eventually found guilty.  That is my understanding, anyways.

 

2/ In general, the rule is dumb.  You can invest in a mutual fund that trades hourly, does it full time, advertises their services, are staffed by CFA's, etc. and all of the investors gains and losses are considered capital gains and losses.  Therefore, if the fund manager had his own money in the fund, is CRA suggesting that their gains and losses are considered business income?  Dumb.  Therefore, if CRA wants to say your trading is business income, just put your assets into some sort of trading entity, such as a trust or corp....of course there are costs involved but the concept seems sounds, which makes CRA's position a bit...dumb.

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"Therefore, if CRA wants to say your trading is business income, just put your assets into some sort of trading entity, such as a trust or corp....of course there are costs involved but the concept seems sounds, which makes CRA's position a bit...dumb. "

 

The same issue, profits on account of income or capital gains classification occurs in a Canadian controlled private corporation.

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