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Paul S. Hewitt, CPA, CA

TAX │ ACCOUNTING │ ADVISORY

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Tax Information for Investors
 


 
The sale of shares by most taxpayers will give rise to a capital gain or a capital loss, of which 50% is taxable in the year of sale.  The gain or loss is the difference between the adjusted cost base (purchase price plus commissions paid) and the proceeds, net of commissions.
 
Often, taxpayers purchase shares in the same company at different dates (and prices).  When this occurs, the taxpayer must keep track of the average cost per share.  When a portion of the shares are sold, the adjusted cost base of the shares sold is equal to the average cost per share times the number of shares sold. 
 
If a taxpayer disposes of shares at a loss and identical shares are repurchased within 30 days of the date of disposition, and the shares are still owned 30 days after the disposition, the loss will be considered a superficial loss.  In this case, what would otherwise be considered a capital loss will be considered a superficial loss, which must be added to the cost of the repurchased shares.  These rules also catch situations where the repurchased shares are held by related and affiliated taxpayers, such as a spouse or a company that you or your spouse controls.
 
When calculating the adjusted cost base of shares purchased in a foreign currency, the taxpayer has the option of using the average exchange rate during the year or the actual exchange rate at the time of the transaction.  The same option is available in calculating the Canadian dollar equivalent of the net proceeds.
 
For individuals and trusts, dividends from Canadian companies are "grossed-up" to a taxable amount, by multiplying the actual dividend by 1.45 (public corporations) and 1.25 (private companies).  This is to estimate the pre-tax income of the corporation that gave rise to the dividend.  The taxpayer also receives a dividend tax credit, which is supposed to reflect the underlying taxes already paid by the company that paid the dividends.  These calculations change when the corporate tax rates change.
 
Dividends from foreign corporations are taxable and usually subject to foreign tax withholdings.  In most cases, the taxpayer will receive a credit for the foreign taxes paid when filing a Canadian income tax return.
 

 
There are several types of bonds to be considered.  Some bonds pay interest, others do not. 
 
For those bonds that do pay interest (quarterly, semi-annually, or annually), the cost to purchase the bond will include the current quoted price of the bond plus interest that has accrued since the last payment date (plus commissions).  The accrued interest paid is deducted, in the year of acquisition, from interest earned on investments.  The adjusted cost base of the bond is the price paid for the bond (which may be different from the face value). 
 
When market interest rates change, the price of bonds will also change.  If the market interest rate goes up, the price of most bonds will fall.  This is called purchasing at a discount.  If the bonds are held to maturity, the difference between the face value and the discounted purchase price will give rise to a capital gain. 
 
Bonds can also be sold prior to maturity.  When this happens, the purchaser will pay the seller the accrued interest from the last payment date to the date of sale.  If the purchase price (excluding the accrued interest) is higher than the adjusted cost base of the bond, a capital gain will arise.
 
Another type of bond is called a "strip" bond, because the coupon interest payments are separated from the underlying bond.  Brokers sell the strip bond separate from the coupon interest payments.  Consequently, strip bonds pay no interest.  Instead, they are sold at a discount that reflects the current market rate of interest to maturity.  Strip bonds are redeemed at maturity for the full face value of the bonds.
 
At the time of purchase, the discount will determine the yield to maturity, which is essentially the interest rate on the bond, compounded annually, that will be earned on the bond until its maturity. 
 
Interest is reported up to the anniversary date of the bond, each year, by multiplying the yield to maturity by the adjusted cost base of the bond before the current period's interest.  The interest reported in the year is added to adjusted cost base, which will be used to calculate the interest to be reported in the subsequent year. 
 
If a strip bond is sold prior to maturity, interest income is recognized up to the date of sale, using the yield to maturity pro rated for the number of days the bond was held.  This amount is added to the cost base of the bond, and if the proceeds are different from the adjusted cost base, a capital gain or loss will arise.
 
Treasury Bills are similar to strip bonds, in that they are always sold at a discount and they never receive interest payments.  The amount of discount and the term to maturity will determine the yield to maturity, or the effective interest rate.  If the T-bills are held to maturity, there will be no capital gain or loss.  The entire difference between the purchase price and the face value will be recognized as interest income.
 
If T-bills are sold prior to maturity, a capital gain or loss will arise, if interest rates have changed during the holding period.  The calculation is the same as that for strip bonds.
 

Warrants, Options, Puts and Calls
 
Some companies issue warrants (or rights) to purchase company stock, at an exercise price, within a certain period of time.  At the time of issue, a warrant may be valued at the excess of the current price for the company shares, less the exercise price.  The actual trading price may be somewhat less than this value. 
 
If the warrants were issued to all current owners of the company's shares, no income need be recognized at the time the warrants are granted.  The warrants will have a cost base of zero.  If the warrants are sold, the entire proceeds, less commissions, will be recognized as a capital gain.
 
If the warrants are exercised and the underlying stock is purchased, the adjusted cost base of the purchased shares will equal the sum of the exercise price and the adjusted cost base of the warrants (if any).
 
A put option gives the holder the right to put, or sell, shares to the writer (seller) of the option, on a specified date.  A call option gives the holder the right to purchase shares from the writer at the price specified in the contract, on a specified date.
 
Most transactions in puts and calls give rise to capital gains or losses.  Puts and calls can be "covered" if the options are a hedge against a position in the actual underlying shares.  For example, an investor who sells short 100 shares of a company's stock may write (sell) 1 put option (equals 100 shares) that allows the holder to sell shares to the investor at a specific price on a certain date.  This allows the investor to "cover" the short position at a guaranteed price (or less).
 
Income Account Transactions
 
Uncovered (or "naked") options do not involve a position in the underlying shares of the company.  Transactions in uncovered options will give rise to income or loss, but the CRA will allow capital gain/loss treatment, if the practice is followed consistently.
 
For those that treat gains on options as income, the income or expense is recognized when the options expire, are bought back, or exercised by the holder.  For those that treat option contracts on the income account, the timing of recognition is relatively straight forward.  When a call option is purchased, the cost of the option is added to the cost base of the shares that are subsequently purchased (if the option is exercised).  If the option is not exercised, the full cost of the option is deducted in the year the option expires.  If the holder of the call option sells it before it expires, the proceeds, less the cost of the option, is included in income when the option is sold.  When a put option is exercised, sold, or expires, the cost of the option is expensed at that time.
 
Capital Account Transactions
 
When purchased put options are subsequently sold or expires, the net gain or loss is recorded at the time the contract is closed or expires.  If the put option is exercised, the cost of the option is deducted from the proceeds from the sale of the shares, reducing the capital gain.
 
When purchased call options are subsequently sold, a capital gain or loss will be reported at that time.  If the call option expires, there will be a capital loss at the time of expiry.  If the call option is exercised, the cost of the call option is added to the cost of the acquired shares, and there is no capital gain or loss.
 
From the seller's (writer's) perspective, when puts and call options are sold, a capital gain is recognized when the options are sold.  If the puts and calls are subsequently purchased to close the contracts, a capital loss is reported when the options are bought back, along with the capital gain that was reported when the options were sold.
 
If a call option is sold and later exercised by the holder, a capital gain will arise at the time of exercise (add option price to the proceeds of sale of the underlying shares).  If a put option is sold and later exercised, there is no capital gain, but the proceeds from the sale of the put option is deducted from the cost base of the shares purchased.  If puts and calls are sold in one year and exercised in the next, the capital gain from the original sale of the options must be reversed (by filing a T1 Adjustment Request).
 

MutualFunds and Exchange Traded Funds
 
Mutual funds allow individual investors to diversify their risk by holding a basket of investments in one fund.  Many mutual funds specialize in particular types of investments, such as blue chip equities, resource equities, tech companies, bond funds, etc...  Investors may wish to diversify further by purchasing shares in several different mutual funds.
 
Exchange Traded Funds (ETFs) are similar to mutual funds, except they try to generate the same return as a stock index. 
 
Both mutual funds and ETFs can generate dividends, capital gains and other income, which are allocated, and taxable, to the unitholders.  Some funds may return part of the capital invested to the unitholders.  Such returns of capital are not taxable, but reduce the adjusted cost base of the units held.
 
Most mutual funds automatically reinvest income that is "distributed" to shareholders.  Consequently, investors should keep track of reinvested funds and additional shares issued to them, usually in December of each year.  All income allocated to shareholders/unitholders and returns of capital are disclosed on an annual T3 Trust income slip.
 

Flow-throughLimited PartnershipsFlow-thru LP
 
Typically, these types of investments are set up to flow-through certain tax benefits to the limited partners, who are usually in a high tax bracket.  Many oil and gas and mining exploration funds are set up in this way.  The limited partnership invests in companies that undertake qualifying exploration and development in Canada.  The limited partnership flows-through the exploration and development expenses to the limited partners, who obtain the deductions against their other income.  Similarly, investment tax credits are flowed-through to the limited partners, who can deduct them against their income taxes for the year.   Flow-through amounts and other information is reported, annually, on a T5013 Statement of Partnership Income.
 
When the limited partnership flows-through expenditures, this reduces the adjusted cost base of the limited partnership units.  Limited partners may generate business losses (income), capital gains (losses), interest and dividend income during the year, which are also flowed-through to the limited partners.  Usually, within a couple of years, the assets of the limited partnership are liquidated, and the limited partnership is wound up.   
 
Typically, the limited partners receive resource mutual fund shares in return for their limited partnership units.  In most cases, this exchange is done on a tax-free rollover basis.  When the resource mutual fund shares are sold, the investor usually reports a capital gain. 
 
The cost of issuing the original limited partnership units are deductible over a five year period.  While the limited partnership is in existence, the limited partnership deducted one-fifth of the issue costs each year.  When the limited partnership is wound up, there is usually 2-4 years of undeducted issue costs.  Each limited partner is entitled to claim his/her share of the issue costs each year until they are fully deducted.
 

Capital Gains or Income?
 
As stated above, most taxpayers report gains and losses on the sale of securities as capital gains and losses.  Only 50% of capital gains are taxable, and capital losses may only be deducted against capital gains (not any other income).
 
Brokers and some frequent traders will be considered to be carrying on the business of trading in securities, depending on the particular facts.  There are a number of factors that are considered in making this determination.  If in doubt, contact me to discuss the tax implications for you. 
 
If you are considered to be in the business of trading securities, 100% of the gain is taxable and 100% of all losses are deductible. 
 
Real Estate Investments
 
Historically, real estate has been a very good investment for most people.  Your own home is considered a principal residence, and when it is sold, the capital gain is not taxable.  However, you and your spouse can only have one principal residence at any point in time.  The sale of a cottage will usually result in a capital gain, if it is held for a reasonable period of time, and the primary use was personal.
 
Some people purchase real estate primarily for the possible appreciation of the property.  Vacant land is held for future redevelopment.  Condominiums are purchased and rented out at a loss, in hopes of a large gain in the future.  Speculators buy properties and flip them soon after taking possession for a quick gain.  Contractors buy fixer-uppers and sell them at a profit.  In situations such as these, the appreciation of the property will usually be treated as business income and be fully taxable in the year of sale.
 
Many investors got surprised when the CRA reassessed the gain on the sale of a property was treated as business income, not as a capital gain.  Quite a few taxpayers appealed at the court level and lost.  The CRA won almost every case that made it to court.
 
In times when the market takes a downturn, many investors will  be forced to sell their properties, often at a loss.  Depending on the facts, many investors will be able to claim the full amount of these losses against their other income.  In the few cases where the CRA has questioned the deductibility of these losses, a simple Notice of Objection has been sufficient to allow the losses to be deductible in full.
 
If you have a situation that may involve a loss on real estate, please contact me to discuss the likely tax consequences and opportunities.