Save tax
and maintain desired exposure
<a href=”http://www2.myto.com/money/tidd_fs.cfm?source_id=&id=1025146”>Last
week</a>, we looked at maximizing the tax savings resulting from capital
losses. This week, we’ll review a concept that is critical to making last
week’s planning ideas work – superficial losses.
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 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 a call option on that same property at the end
of the sixty-one day period.
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 <a href=”http://www.ccra-adrc.gc.ca/E/pub/tp/i387r2et/i387r2e.txt.html”>IT387R2
– Meaning of Identical Properties</a>. Very basically, it states that
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.
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.
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 a
corporate class fund structure (CI Sector Fund Ltd.): 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.
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.
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
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 AIC’s Tax Smart Team, 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. <a href=”http://www.waterstreet.ca/cgi-bin/Article.pl?nextState=DisplayArticle&file=.^data^articles^2000^article200001220.txt”>
Click here</a> to view the article.
These last
two articles have nicely covered the issue of capital losses, tax planning,
superficial losses and portfolio exposure. However, if you’re even thinking
about some of these strategies, make sure you seek the help of 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@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, and Manitoba.