Question

Why is it important to make distinction between capital gain and income?

Answer 1

Capital Gain or Income?

Since capital gains are only half taxed, the distinction between capital gains and income is very important.

Capital property is property on which any gain is taxed as a capital gain. Only half of a capital gain is included in income in your tax return — the “taxable capital gain”. Thus, the effect is that capital gains are taxed at half the rate of ordinary income such as interest or employment income.

Not all gains are capital gains. If you are in the business of buying and selling goods — for example, operating a retail store — then obviously your gains from the goods you sell are business profits, which are fully taxable, and not capital gains.

Some types of gains fall close to the line. The Income Tax Act defines the term “business” — the income from which is fully taxable — as including an “adventure in the nature of trade”. This phrase has been interpreted in hundreds of reported court cases.

If what you are doing is a “business” or an “adventure in the nature of trade”, then your gain will be fully taxable as the sale of inventory. If it is not, then your gain will be only half taxed as a capital gain. On the flip side, business losses are fully deductible from income, while capital losses are only half-deductible and normally only against taxable capital gains.

So how do you determine the difference between capital property and inventory?

Basically it comes down to intention. If you buy a property with the intention of selling it, then you are considered to be in business and the gain will be fully taxed as business profit.

Real estate

The most difficult issues usually arise with respect to real estate. You might build a home to live in (capital), but also with plans to sell it (inventory). You might buy land on which to develop a shopping plaza to lease out (capital), or on which to develop a subdivision of new homes that you will sell (inventory).

The Canada Revenue Agency’s Interpretation Bulletin IT-218R, “Profit, Capital Gains and Losses from the Sale of Real Estate” (available at cra.gc.ca) provides the Agency’s views on whether the purchase and sale of real estate will be treated as leading to business profits or capital gains. Paragraph 3 of the Bulletin sets out twelve factors that the CRA considers relevant:

the taxpayer’s intention with respect to the real estate at the time of its purchase;

feasibility of the taxpayer’s intention;

geographical location and zoned use of the real estate acquired;

extent to which the taxpayer’s intention is carried out;

evidence that the taxpayer’s intention changed after purchase of the real estate;

the nature of the business, profession, calling or trade of the taxpayer and associates;

the extent to which borrowed money was used to finance the real estate acquisition and the terms of the financing, if any, arranged;

the length of time throughout which the real estate was held by the taxpayer;

the existence of persons other than the taxpayer who share interests in the real estate;

the nature of the occupation of the other persons referred to in (i) above as well as their stated intentions and courses of conduct;

factors which motivated the sale of the real estate;

evidence that the taxpayer and/or associates had dealt extensively in real estate.

In determining your intention with respect to the property, the Courts have also developed the concept of a “secondary intention”. If you have an intention of using the property as capital property, but a secondary intention of selling it if the main intention does not pan out, then the property may be considered to be inventory and the gain fully taxable. The CRA’s Interpretation Bulletin IT-459 discusses this issue. Of course, just about everyone will sell their property if the right offer comes along, so the secondary intention has to be something more than just a willingness to sell if the price is right. There is often no clear dividing line, but the Federal Court of Appeal said in the 2008 Canada Safeway case that for there to be a secondary intention, it “must have been an operating motivation in the acquisition of the property”

hope this will help u.....