The limitation in the carry-forward/carry-back mechanism in Canada’s income tax system is that the capital losses may be carried back only three years.
By Steve Z. Ranot and James A. DeBresser, Business Valuators
Canada’s income tax system has limited equity built into its loss carry-forward and loss carry-back mechanism. If a taxpayer realizes a capital gain in 2006, the taxable portion is included in the taxpayer’s income and income tax is paid on this amount. If the same taxpayer realizes a capital loss of the same magnitude in 2007, the taxpayer has the option to apply the 2007 loss against the 2006 gain. As a result, the taxpayer is permitted to file a loss carry-back and recover the income taxes paid on the capital gain. This makes economic sense since overall the taxpayer has just broken even. Accordingly, no income tax should have been paid overall.
The Limitation in Carrying Capital Losses Only Three Years Back
The limitation in the carry-forward/carry-back mechanism is that losses may be carried back only three years. So, if the same situation occurs with a gain in 2003 and an equal but offsetting loss in 2007, no carry-back is allowed and the taxpayer is left hoping that there will arise one-day sufficient capital gains against which to apply the unused 2007 loss. While this apparent inequity exists in the Income Tax Act, we can only hope that the Child Support Guidelines (“the Guidelines”) do not exacerbate this situation.
Let’s consider the plight of Pat, the non-custodial parent. Pat earns $100,000 in employment income each year from 2004 to 2008. In addition, Pat realized a capital gain of $25,000 in 2004. Pat realized no other capital gains or losses until the decision was made in 2008 to buy $50,000 in CIBC shares which dropped in value by 50% that year and Pat realized a $25,000 capital loss. Pat was upset to learn that the $25,000 loss could not be applied against the gain in 2004. Pat was further upset to learn that the Guidelines do not specifically state that capital losses are deducted from line 150 income to determine a payer’s income.
Both the non-taxable and the taxable portion of Pat’s 2004 capital gain was included in Pat’s income and Guidelines support was determined on that amount. Would it be equitable not to give Pat a break on support payments when a capital loss is realized?
Approaches that allow Actual Capital Losses to Reduce Income
According to Schedule III of the Guidelines, line 150 income is adjusted for items including “replace taxable capital gains . . . by the actual amount of capital gains . . . in excess of . . . actual capital losses”. Some have interpreted this to mean that net taxable capital gains are adjusted upward but in the year of net capital losses, the amount is left at nil as the schedule only refers to adjusting gains. As this appears inequitable, there are two possible approaches which would allow the actual losses to reduce income:
(a) A capital loss is a negative capital gain – following the formula but insert a negative number thereby adding negative income to lower Guidelines income;
(b) Refer to paragraph 17(2) of the Guidelines – non-recurring losses including capital losses may be ignored if the courts determine it would be appropriate to do so. This appears to imply that, in the absence of any “appropriateness”, actual capital losses may be considered in the calculation of Guidelines income.
With reference to (b), it may be that the intention of 17(2) was to allow the courts to ignore discretionary capital and non-capital losses created by the purchase of tax shelters or the use of hedging or straddle transactions.
Triggering Sufficient Losses to Offset Earlier Gains
We continue to look to the courts for guidance, but one thing is clear and that is that if you have realized capital gains from the early part of 2008 and now have accrued but unrealized capital losses, you should strongly consider selling your losers to trigger sufficient capital losses to offset the earlier gains this year. Not only will this eliminate a portion of your 2008 income tax liability, it will also reduce Guidelines income.
If you have paid any capital gains tax in 2005 to 2007, you may also wish to realize sufficient losses in 2008 so that you may carry these losses back to recover taxes paid previously. For 2005 gains, this is your final opportunity.
With 2009 just around the corner, we must also be cognizant of the deadline to:
(a) Have your clients pay all arrears spousal and child support in order to gain the tax deduction. While spousal support is obviously tax-deductible, the non-payment of child support where spousal support is also owing to the same parent will lead to a grinding down of the deductible spousal support for that year; and
(b) Finalize written agreements or orders that cover periodic spousal support payments made in 2007 in order to enable these payments to be made retroactively deductible to the payor.
Steve Z. Ranot, CA·IFA/CBV, and James A. DeBresser, CA·IFA/CBV are partners in Marmer Penner Inc., a Business Valuator and Litigation Accountant firm in Toronto, Ont.
Reprinted with Permission