TaxMatters@EY – February 2022

Alan Roth, Toronto

To answer this question, it’s necessary to step back a bit and consider the situation in a broader context.

A deceased individual is deemed to dispose of each capital property they owned immediately before their death for proceeds equal to the property’s fair market value at that time, subject to certain exceptions.¹ This property may include the deceased’s principal residence. However, the principal residence exemption may be used to exempt all or some of any resulting capital gains from taxation if the applicable conditions are met.²

The deceased individual’s estate acquires the property as a consequence of the individual’s death at a tax cost equal to the deemed proceeds amount. If the property is not disposed of right away by the estate, the value of the property may increase or decrease before it is distributed or sold, triggering a capital gain or loss in the estate. While declines in the value of real estate are somewhat rare these days, the costs incurred to sell the property may create a capital loss even if the property retains its value.

Let’s consider an example. Say Corinne dies on January 5, 2022 and the fair market value of her home on that date is $750,000. This value is significantly higher than the price she paid for the home 30 years ago. Corinne ordinarily inhabited the home for the entire 30 years she owned it. Although Corinne is deemed to dispose of the home immediately before her death for proceeds of $750,000, the home would likely be able to be designated as her principal residence on her terminal income tax return in respect of each year she owned the home to exempt the entire capital gain from taxation. Corinne’s graduated rate estate (GRE)³ acquires the home for a tax cost equal to $750,000. In the months that follow, the housing market experiences a decline as a result of rising interest rates. On June 1, 2022, the GRE sells the home to an arm’s-length party for proceeds of $700,000. None of the GRE’s beneficiaries or anybody related to the beneficiaries inhabited or otherwise used the home between Corinne’s death and the sale of the home. Can the GRE claim the $50,000 capital loss? The answer may depend on whether the home is considered personal use property.

Personal use property is capital property that is held primarily (i.e., more than 50% of the time) for personal enjoyment. It may be a home or cottage, a boat, a car, jewellery or other personal effects used or enjoyed by an individual or a person related to the individual. If a property is held by a trust, it is considered to be personal use property if it is used primarily for the personal use or enjoyment by a beneficiary of the trust or any person related to the beneficiary.⁴ If a personal use property is sold or otherwise disposed of for proceeds that are less than its original cost, the resulting loss is deemed to be nil under the Income Tax Act (the Act) and, therefore, cannot be claimed⁵ unless the property is listed personal property.⁶

A Canada Revenue Agency (CRA) technical interpretation⁷ describes a scenario in which an individual died holding a cottage property. The property was acquired by the individual’s estate at its fair market value on the individual’s death and was not used by any of the estate’s beneficiaries. The property was held on the basis that it was to be disposed of when certain matters concerning the estate were resolved, such as the obtaining of probate and the settlement of possible legal issues. In the intervening period, the property declined in value. The CRA was asked whether the loss realized on the disposition of the property would be treated for tax purposes as a capital loss from the disposition of a capital asset rather than personal use property, such that the capital loss would not be denied and could, instead, be used by the estate.

The CRA noted that real property generally qualifies as a non-depreciable capital property to the estate on the assumption that the property has not been rented or otherwise used to earn income. The CRA stated the key to the answer to the question posed is whether the property was used primarily for the personal use or enjoyment of the beneficiaries of the deceased or persons related to them between the death and the sale of the property. The CRA noted that in the described scenario a cottage owned by an estate which has not been used by any of the estate’s beneficiaries or any person related to the beneficiaries would not meet the definition of a personal use property under the Act. Therefore, provided the cottage is not acquired by a person affiliated with the estate, a capital loss realized on the sale of the property by the estate would not be deemed to be nil and could, instead, be used to reduce or offset capital gains realized by the estate. A person and an estate or trust are affiliated if the person is a majority-interest beneficiary of the trust or the person is affiliated with a majority-interest beneficiary⁸ of the trust under any other part of the definition of affiliated persons (generally, certain related parties) found in subsection 251.1(1) of the Act.

Although not discussed in the CRA interpretation, if the estate sells the property to a person affiliated with the estate, the “suspended loss” rules may apply to deny the immediate recognition of the capital loss. Under those rules, the capital loss is suspended if the transferor or an affiliated person acquires the same non-depreciable capital property or an identical property in the period beginning 30 days before and ending 30 days after the disposition, and the transferor or affiliated person owns the property at the end of that period. The denied loss is suspended until certain triggering events occur (e.g., the transferred property (or identical property) is subsequently disposed of to an arm’s-length party).⁹

Returning to the example of Corinne and her GRE, since her home was not used primarily for personal use or enjoyment by any of the GRE’s beneficiaries or anyone related to them, Corinne’s home is not considered to be personal use property and, therefore, the capital loss realized is not deemed to be nil. The suspended loss rules don’t apply as the GRE sold the home to an arm’s-length party. How can this capital loss be used now in this scenario? What if the GRE has no realized capital gains against which this capital loss can be applied?

The tax rules allow the personal representative (i.e., the trustee) of a GRE to elect to treat all or a portion of capital losses that arise in the first year of a GRE as capital losses of the deceased individual for the year of death.¹⁰ Allowing these losses to be claimed in the deceased’s terminal income tax return may offset part or all of the capital gains realized on the deemed disposition of capital property on death. The personal representative must make the election in writing to carry the losses back to the terminal return. The deadline for making the election is the later of the filing deadline for the terminal-year income tax return and the filing deadline for the GRE’s return for its first taxation year.¹¹

To give effect to the election, the personal representative must file an amended terminal return that includes the application of these losses. It is the CRA’s administrative policy that the GRE’s return must be assessed before the reassessment giving effect to the election can be processed.¹²

In Corinne’s case, if her GRE does not include any realized capital gains in the first taxation year of the GRE after her death, and to the extent that her terminal income tax return includes any realized capital gains, it may be beneficial for the GRE’s personal representative to elect to carry back all or part of the $50,000 capital loss to Corinne’s terminal income tax return so that it may be used there.

In conclusion, the ability of an estate to sell a home and realize any resulting capital losses depends on the use of the home during the period it is held by the estate. Therefore, the legal representative should consider whether any beneficiaries or anyone related to them intend to use the home during this period if it’s likely that the sale of the home by the estate will result in a capital loss. In addition, the tax rules provide considerable flexibility for the claiming of capital losses in the first year of a GRE by providing a GRE with the option to elect to carry back those losses to the deceased’s terminal income tax return.

Iain Glass and Alan Roth, Toronto

On January 14, 2022, the CRA updated its website on the new filing and reporting (proposed Schedule 15) requirements for trusts. It states that the CRA will only begin to administer the proposed additional reporting requirements announced once the related draft legislation is enacted. In the meantime, the CRA will continue to administer the existing rules for trusts. The additional reporting requirements will not be part of the published 2021 T3 return.

Background

Significant changes to trust reporting requirements were proposed in the 2018 federal budget and subsequently released as draft legislation (including, for example, amendments to section 150 of the Income Tax Act and draft regulation 204.2) on July 27, 2018.

Québec announced in its 2021 budget its intention to harmonize with the federal rules. Refer to EY Tax Alert 2021 Issue No. 11. Following the above announcement by the CRA, Revenu, Québec has stated on its website that for 2021 it is relaxing the obligation to provide additional information on Form TP-646-V, the Trust Income Tax Return.

The proposed legislation is still in draft format and was not mentioned in the recent federal economic and fiscal update delivered on December 14, 2021. In addition, the CRA has not yet issued the 2021 T3 guide.

As currently proposed, these additional reporting requirements are effective for taxation years ending after December 30, 2021 and will increase the compliance burden for existing trusts and will create an annual T3. return filing requirement for many trusts that are not required to file under current rules. For a summary of the new reporting requirements, refer to TaxMatters@EY, March 2020, “Additional trust reporting requirements coming soon - update.”.

Implications

Although these proposals are not law, steps may be taken to gather the new required information with respect to settlors, trustees and beneficiaries in anticipation of the eventual enactment of these proposals and in the event that the Department of Finance does not change their effective date

We are waiting for an update from the Department of Finance on the status of the draft legislation and whether it will consider changing the effective date of these proposals. We will advise when more information is available.

Lucie Champagne, Alan Roth, Andrew Rosner and Candra Anttila, Toronto

Frequently referred to by financial planning columnists, our mobile-friendly 2022 Personal tax calculator lets you compare the combined federal and provincial 2022 personal income tax bill in each province and territory. A second calculator allows you to compare the 2021 combined federal and provincial personal income tax bill.

You’ll also find our helpful 2022 and comparative 2021 personal income tax planning tools:

• An RRSP savings calculator showing the tax saving from your contribution
• Personal tax rates and credits by province and territory for all income levels

In addition, our site offers you valuable 2022 and comparative 2021 corporate income tax planning tools:

• Combined federal-provincial corporate income tax rates for small business rate income, manufacturing and processing income, and general rate income
• Provincial corporate income tax rates for small business rate income, manufacturing and processing income, and general rate income
• Corporate income tax rates for investment income earned by Canadian-controlled private corporations and other corporations

You’ll find these useful resources and several others — including our latest perspectives, thought leadership, Tax Alerts, up-to-date 2022 budget information, our monthly TaxMatters@EY and much more — at ey.com/ca/tax.

Gael Melville, Vancouver, and Winnie Szeto, Toronto

In a recent Tax Court of Canada case, the court was asked to consider whether an allowable business investment loss (ABIL) arose where a loan made to a corporation subsequently went bad. The difficulty the taxpayers faced was in convincing the court that the direct recipient of the loan, which was not itself a small business corporation (SBC), was simply a conduit for funds loaned to other corporations that were in fact SBCs. The taxpayers’ arguments were unsuccessful and serve as a reminder that close attention must be paid to structuring business transactions.

What is an ABIL?

An ABIL is a special type of capital loss that can be used more flexibly than an ordinary capital loss for a limited period of time. Unlike allowable capital losses, which may be deducted only against taxable capital gains, an ABIL may offset income from any source in the year the loss is incurred.

If the ABIL is not fully claimed in the year it’s incurred, it may be claimed as a non-capital loss that may be carried back up to 3 years and forward up to 10 years to offset income from any source. Although non-capital losses have a 20-year carryforward period, this extension does not apply to a non-capital loss resulting from an ABIL. Any part of an ABIL that is not used in the 10-year carryforward/3-year carryback period becomes a net capital loss, which may be carried forward indefinitely but can be deducted only against taxable capital gains.

An ABIL is 50% of a business investment loss. A business investment loss can only arise on the arm’s-length disposition of shares or debt of a corporation that was an SBC at any time during the preceding 12 months before the disposition. An SBC is essentially a Canadian-controlled private corporation where more than 90% of the fair market value of its assets is attributable to assets that are:

• Used principally (more than 50%) in an active business carried on primarily (more than 50%) in Canada
• Shares or debt of one or more SBCs that are connected to it (the term connected generally means the corporation owns more than 10% of the issued share capital of the other corporation); or
• A combination of the above

Facts of the case

The case involved two individuals, Mr. X and Ms. X,¹ who were each denied their claims for ABILs and non-capital loss carryforwards for their 2014 and 2015 taxation years, respectively. Mr. X and Ms. X jointly held shares in a numbered company, Xco.

In 2006, Ms. X and her brother decided to launch a new fashion and furniture retail business. They set up two corporations, each of which was owned 45% by Ms. X and 55% by her brother. One corporation, Opco, would run the retail business, and the second corporation, Leaseco, would lease the business premises to Opco.

To provide their share of the financing for Leaseco and Opco, Mr. X and Ms. X used their savings, took out loans and withdrew money from their registered retirement savings plans. They then made a series of large deposits into Xco’s bank account from November 2006 to October 2007. Almost all the money deposited into Xco’s bank account was immediately transferred to Leasco’s bank account.

The loans ultimately went bad and Mr. X and Ms. X claimed business investment losses totalling nearly $850,000 in their 2014 income tax returns. In their 2015 income tax returns, they each claimed non-capital loss carryforwards relating to the unused portion of the ABILs. The Canada Revenue Agency (CRA) reassessed them and disallowed the ABIL and non-capital loss carryforward claims. Mr. X and Ms. X both appealed the decision.

Tax Court decision

The Tax Court dismissed the taxpayers’ appeals.

At trial, the taxpayers agreed that Xco was not an SBC but argued that it was merely a conduit for the loans to Leaseco and Opco. Because Leaseco and Opco were both SBCs, the taxpayers argued that their ABIL claims — and resulting non-capital loss claims — should be allowed. On the other hand, the Minister of National Revenue took the position that the transactions were straightforward — Mr. X and Ms. X loaned money to Xco, which in turn loaned money to Leaseco; since Xco was not an SBC, the initial loan to Xco could not give rise to an ABIL.

The court first considered the documentary evidence and noted that it all supported the notion that the taxpayers made a loan to Xco. For example, a schedule to Xco’s T2 corporate income tax return for the year ended July 31, 2007 showed that the corporation had loans receivable of around $800,000 and outstanding shareholder loans of around $780,000.

The accountant who designed the corporate structure for Opco’s business also prepared the corporate income tax returns. The court said that fact indicated that the accountant took the position the taxpayers loaned money to Xco, and Xco then loaned the funds to Leaseco. Furthermore, the fact that the balances in the shareholder loan and loan receivable accounts were not equal showed that different adjustments had been made to each account, which ran counter to the idea of Xco acting simply as a conduit.

At the hearing, only Ms. X gave evidence on behalf of the taxpayers and the court found her testimony in relation to Xco being a conduit unreliable. Although she asserted that it was preordained that the money flowed through Xco to the other corporations, the court did not find that these assertions were supported. The court also drew an adverse inference from the fact that the taxpayers did not call Ms. X’s brother as a witness, who was a 55% shareholder in both Leaseco and Opco and who, according to Ms. X, was responsible for the finances of the business and dealt with the accountant.

The court also listed the explanations it found to be missing from the taxpayers’ evidence, explaining the significance of each one. For example, the court noted that the taxpayers did not explain why they deposited money into Xco’s bank account rather than simply depositing it directly into the accounts of Leaseco or Opco. In the absence of an explanation, the court found it was more likely than not that the money was a loan to Xco. Similarly, the court questioned why, if Xco had merely been a conduit, the ABILs claimed were in respect of loans to Xco rather than in respect of loans to Leaseco and Opco.

In conclusion, the court found that the taxpayers lent money to Xco rather than to Leaseco or Opco, and because Xco was not an SBC, the minister was justified in denying the taxpayers’ ABIL and non-capital loss carryforward claims.

Lessons learned

As the court noted towards the end of the reasons for judgment, this was a sympathetic case where the taxpayers lost significant sums of their own money. It appears that had they structured the loans differently, they would have been able to claim ABILs (and non-capital loss carryforwards) for the losses they sustained.

As the court stated, “in [Canadian] tax law form matters.” The court must apply the law to the transactions that actually took place rather than those the taxpayer wishes had taken place.

This case is a good reminder to taxpayers to take care when structuring their business ventures and to consider possible tax ramifications.

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Tax Alert 2022 No. 02 – CRA provides update on home office expense deduction
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