From Our Canadian Bureau: Tough year creates planning opportunity By Dan Hallett December 10, 2001

Stock markets all over the globe have fallen off a cliff so far this year - and dragged many investors along for the ride. Canadian stocks have shed about 21 per cent of their value, while U.S. and overseas stocks have sunk 14 and 19 per cent, respectively, in Canadian dollar terms so far this year. While nobody likes to lose money, there is a way investors may be able to use their losses to offset gains in other years to ease the pain.

Capital gains and losses

Capital gains and losses arise from selling property known as "capital property". A capital gain (or loss) simply results from selling capital property at a price that is greater (or less) than its original cost. Stocks, bonds, and investment funds are among a long list of items included in the definition of capital property.

Capital gains and losses must be aggregated before the tax impact can be determined. Suppose Tom ended this year with the following with respect to his capital property transactions:

• Capital gains distributions from mutual funds of $2,000;
• Capital loss from stock sale of $6,000;
• Capital gain from the sale of mutual fund units of $2,500; and
• Capital gain from the sale of a small rental property of $4,000.

All capital gains and losses must be "matched" together to determine an aggregate net gain or loss for the year. In Tom's case, he has a net capital gain of $2,500 ($2,000 - $6,000 + $2,500 + $4,000). For 2001, only half of that net capital gain - or $1,250 - is taxable at his marginal tax rate.

If we take Tom's case above, but assume there was no gain or loss from the sale of the rental property, he would have a net capital loss of $1,500. Half of that, $750, would be called an allowable capital loss.

Note that while taxable capital gains are added to other income, allowable capital losses cannot reduce income from any other sources. Capital losses can only be used to reduce other capital gains. This, and the special rules surrounding the use of losses, necessitates careful planning this year.

Capital loss planning

While net capital losses cannot offset regular sources of income (i.e. employment income, interest, dividends, pensions, rental income, business income, etc.), they can be used in other years to offset taxable gains in the past or in the future.

Net capital losses can be carried forward indefinitely. Hence, as the tax laws stand today, a net capital loss resulting from 2001, can be used against capital gains at any point in the future. However, net capital losses can also be carried back three taxation years prior to the year the net loss was realized. In other words, net capital losses resulting in 2001 can be carried back to any of the following years: 1998, 1999, or 2000.

Suppose Susan's investment activity and other capital transactions result in a net capital loss of $12,000 (allowable amount is $6,000 for 2001 and future years). Let's also suppose that she had taxable gains of $5,000 in each of the last three years. Susan has three choices:

• She can keep the $12,000 loss to offset gains in the future;
• She can carry that loss back to 1998, 1999 or 2000; or
• She can do some combination thereof.

The capital gains inclusion rate is that proportion of the total net gain that must be included in income, and taxed for the year. For losses, it refers to the proportion of total net capital losses that can be used to offset other taxable gains. This inclusion rate has changed many times over the years, but we'll focus only on the years that apply to Susan:

• 1998 and 1999: 75 per cent;
• 2000: three rates applied, but let's assume 67 per cent was Susan's rate; and
• 2001 and beyond: 50 per cent.

When capital losses are carried over into other years (whether its back or forward) the loss gets converted to receive the same "inclusion rate" that applied to that year.

For instance, if Susan carries her loss forward, she'll be able to use $6,000 (the allowable amount) against taxable gains in the future - assuming of course that the inclusion rate remains at 50 per cent. However, if she carries the loss back to 1998, she'll be able to get a bigger bang for her buck because of the higher inclusion rate for that year - allowing her to offset up to $9,000 in taxable gains in years where a 75 per cent inclusion rate applied.

Assuming Susan's income hasn't changed all that much, it becomes very apparent that Susan should take full advantage of her ability to carry back her net capital losses. There are two reasons for this. Not only was the capital gains inclusion rate higher in those years, but so were the overall tax rates. Hence there is a big benefit to carrying losses back, rather than forward, in her case.

Without going into too much detail, offsetting Susan's 1998 taxable gain of $5,000 would result in a $2,400 tax refund - and she'd still have $5,333 left of her $12,000 total net capital loss to use for other years. She would still have enough to offset $4,000 of her 1999 taxable gain - saving her another estimated $1,800 or so in taxes for that year. That uses up the entire gain and allows Susan to recoup $4,200 in taxes paid in previous years.

If, instead, she expected a $6,000 taxable gain in 2002, she could hold onto her loss and use it for that year. However, it would likely only save her about $2,400 in taxes and would use up her entire $12,000 net capital loss.

By carrying her losses back instead of forward, Susan can reap $1,800 in additional tax savings. Further, by keeping the loss to use against 2002 gains, she will have to wait an extra year before seeing any of her tax savings. Carrying back this year's loss can be done as soon as her 2001 tax return is filed - thereby allowing her to realize the savings a full year sooner.

Superficial loss

Individuals planning to sell current holdings to generate capital losses will want to get very familiar with something known as the superficial loss rules (similar to the U.S. wash sale rules). To discourage the selling of securities that is only meant to generate a tax benefit, the Canada Customs and Revenue Agency (CCRA - formerly Revenue Canada) says that superficial losses arising in a year will not be available for use in any year. Rather, the superficial loss will be added to the cost of the property sold. In such a case, it's not a total loss (sorry for the pun) but it prevents the type of tax planning mentioned above.

Superficial loss defined

Superficial losses are defined by section 54 of the Canadian Income Tax Act (ITA). If a capital loss is realized in such a way that it falls under the definition in the ITA, the loss cannot be used in the year realized but, rather, it will be added to the adjusted cost base of the property to reduce future gains or increase future losses.

A capital loss will be defined as superficial if, during the thirty days on either side of the date of sale that triggered the loss, the taxpayer or an affiliated person (i.e. his/her spouse or a corporation controlled by the taxpayer or his/her spouse) purchased that same property, or one that is identical to that property. Also, if that property or a "right to purchase" that same property is owned at the end of the period noted above, the loss will be deemed superficial.

In other words, during the thirty days before and after the sale date, no purchases can be made in the property to be sold or a property that is deemed to be "identical" by the taxpayer or a person affiliated with him/her. Hence, there is a sixty-one day period of which to be aware. Further, neither the taxpayer nor an affiliated person can own any quantity of that property or a call option on that same property at the end of the sixty-one day period.

Identical property

The definition mentions that buying "identical property" during a certain period can also render a capital loss superficial. Canada Customs and Revenue Agency (CCRA - formerly Revenue Canada) outlines its official position in interpretation bulletin IT387R2 - Meaning of Identical Properties. Very basically, it states "…identical properties are properties, which are the same in all material respects, so that a prospective buyer would not have a preference for one as opposed to another. To determine whether properties are identical, it is necessary to compare the inherent qualities or elements, which give each property its identity".

It becomes very clear that the application of this rule is open to interpretation, but IT387R2 and an example may help.

Avoiding superficial losses

Rob purchased CI Global Telecommunications Sector fund a little over a year ago at about $53. On November 1, 2001, he decided to "average down" his cost and bought more units at $17. While the fund recently recovered to $19 this week, the overall decline has been painful for Rob to watch. He doesn't hold any hope for this fund in the short term and wants to trigger his loss before year's end so he can save some taxes on other gains.

To avoid having his capital loss classified as superficial, Rob will have to wait until December 2 to sell his fund to trigger the loss. To make sure he will be able to use that loss this year, he can buy back the same fund no earlier than January 2, 2002.

Rob must wait until December 2 of this year to sell his fund because he just bought more units on November 1. Since the superficial loss rules say that no purchases can occur in the thirty days prior to the date of sale that triggers the loss, Rob must make sure a full thirty days passes before he sells. On the other side, he must also make sure to wait an additional thirty days before buying back into the same fund. If he adheres to these rules, he will be able to use the loss to offset other gains this year, or carry back to previous years.

Keeping desired exposure

We know that by following the timeline above, Rob can avoid the superficial loss, thereby maintaining full use and flexibility of his capital loss. Suppose instead that Rob wanted to trigger the loss, but feared missing out on a big run during the thirty days he had to be completely out of that fund? Can he trigger the loss, stay out of that fund, or an "identical one", altogether and still catch an upturn in the telecom sector? Yes.

When Rob first sells his fund, he can simply switch to a similar, though not identical, fund offering the same exposure. There are a number of funds from which to choose, such as AIM Global Telecommunications Class, Fidelity Focus Telecommunications, and Franklin World Telecom. Frankly, it doesn't even matter much which fund is chosen if the goal is to eventually return to the original CI fund. One final note on Rob's situation, since this particular fund is in CI Sector Fund Ltd. corporate class fund structure : simply switching to another class under the same "corporate umbrella" will not trigger the loss. Rob must exit the corporate class structure completely to realize his loss.

Indexing

We know indexers have taken a beating for sticking to their knitting this year. However, the identical property rules noted above are flexible enough to allow index investors to maintain substantially the same exposure without getting snagged by the superficial loss rules. For instance, those who have held the Barclays ETF tracking the S&P/TSE 60 stock index, i60 units (TSE: XIU), will be looking at a significant loss this year. However, investors can sell their i60s and move to State Street's Dow Jones Canada 40 ETF (TSE: DJF) to realize a capital loss and maintain Canadian large cap exposure.

In fact, indexers can do one better. Holders of i60s can even switch to the Barclays ETF tracking the capped version of that same 60 stock large cap index - the i60C units (TSE: XIC). Currently, there really isn't any difference but there definitely is a material difference between the two. Late last summer, Nortel Networks was the darling of the Canadian stock market, but it also held a dominant position, by occupying a full 45% of the i60 units. Since diversification is one of the cornerstones of index enthusiasts, Barclays launched a capped version of their popular, and uncapped, i60 units, which will limit any single stock to 10% of the fund's value. Now that the air has been let out of the Nortel balloon, the capped version has holdings in weightings that mirror those of the uncapped version. However, the difference is obvious and material to the extent that the two would not be considered identical properties - ideal for realizing capital losses.

Sector ETFs can also be used to maintain stock exposure. Most holders of Nortel and Celestica will be sitting on big fat losses at this point. Since these two stocks make up half of the iIT ETF (Canadian Information Technology iUnits), it can be used to maintain exposure to the tech sector, and the two stocks should they take a run up during the 30 day "cooling off" period noted in the superficial loss rules.

This same reasoning can be extended to TD Asset Management's capped and uncapped TSE 300 ETFs.

A matter of style

If holding a sector fund, such as the telecom fund above, it's fairly easy to switch to another fund offering similar exposure. However, what if the fund in question is instead a broad based equity fund with distinctive style characteristics? Then it becomes a bit tougher.

Jan wants to sell her Synergy Canadian Momentum Class fund, which has lost more than 30 per cent over the past year. This fund invests in larger Canadian companies using an earnings momentum style. Jan can realize her loss by selling this fund and buying either the AIM Canadian Premier Class or the CI Landmark Canadian. Both follow a very similar style that would allow her to maintain the same style and asset class exposure while still realizing the capital loss.

No available substitutes

There may be instances when you hold an investment that is truly unique. It could be a stock that you've bought, not just because you like its industry, but because this particular company possesses a true competitive edge over its peers. However, if your holding is currently showing a paper loss that you'd like to benefit from but you don't want to be out of the stock, there is one option.

Have your registered retirement savings plan (RRSP) buy it. Don't transfer it directly to your RRSP, but sell it outright and have your RRSP plan buy it immediately. If you transfer a security at a loss directly to your RRSP, you will simply lose the use of that capital loss altogether. However, effectively do the same thing in two distinct and separate transactions and you can maintain exposure and full use of the loss, without any time constraint.

This two-step RRSP strategy works because registered tax-deferred plans (i.e. RRSP, RRIF, LIRA, LIF, LRIF, etc.) are not considered to be "affiliated persons" according to our tax laws. Recall that superficial losses occur when an affiliated person purchases property that you've just sold at a loss during a specified time frame.

Tim Cestnick, managing director of the Tax Smart Team for AIC Funds, wrote a great article on this very topic back in January 2000. While the capital gains inclusion rate is out of date, the concept remains valid today.

Seek professional help

While this article nicely covers the issue of capital losses, tax planning, superficial losses and portfolio exposure, it's not a replacement for personalized advice. However, if you're even thinking about some of these strategies, make sure you seek help from a real tax pro - something I am not - to make sure it doesn't cost you more in the end.

Dan Hallett, B.Comm., CFP, CFA is Senior Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@indexfunds.com. Sterling Mutuals Inc. is registered as a mutual fund dealer in the Canadian provinces of Ontario, British Columbia, and Manitoba.