The announcement by the Minister of Finance Jim Flaherty on Halloween to tax income trusts on the same basis as corporations sent shivers down the spine of the stock markets in the days following. Within three days, investors lost $20 billion.
Retirees felt the immediate sting of the minister’s new tax effects on the value of their portfolios. Future pensioners will feel their wallets shrink in the years ahead as they pay taxes twice on trust income.
Foreign investors were shocked that a sophisticated country like Canada could undermine tax rules without consulting anyone, with no advance warning, and contrary to all election promises not to tax income trusts.
To be sure, tax planning is about timing. Our income tax is as much a tax on transactions and events as it is a tax on income. A fundamental principle of taxation of investments is that one pays tax only when one disposes of investments. In exceptional circumstances, the Income Tax Act deems one to dispose of one’s assets.
To date, investors’ losses have been mostly on paper. Nevertheless, paper losses are real economic losses. Now is the time to mitigate some of those paper losses in planning 2006 tax returns.
Tax planning involves controlling taxable transactions. Therefore, one should generally defer recognizing capital gains and accelerate the recognition of losses. Hence the importance of tax-loss selling before year-end.
The Conservative proposal to impose a new distribution tax on publicly traded income trusts became effective immediately even though Parliament will not enact the legislation for several months. Thus, now is the time for portfolio pruning.
Individuals with losses on their income trusts should clean out their portfolios by Dec. 22 to trigger sufficient capital losses that they can offset against any capital gains that they realized in the year.
Generally, 2006 has been a good year for stock indexes. If, however, you were unlucky enough to have invested late in the year in oil stocks or got hit by the income trust debacle, you can carry back any unused capital losses to the three prior years to trigger a refund of taxes that you paid on capital gains in 2005, 2004, and 2003.
You simply indicate that you wish to apply capital losses against prior year gains on your 2006 tax return and the CRA will do the rest for you.
If you are optimistic enough to really believe that your income trusts or oil stocks will rise again to become stars in the future, you can “bed and breakfast” them: sell and then repurchase the shares - make your broker happy - but wait for at least 30 days before you buy back the shares.
Otherwise, any losses that you trigger on the shares will be “superficial” and you will not be able to offset them against capital gains. This is entirely legitimate tax mitigation and not subject to any anti-avoidance rule.
It is quite unlikely that the minister of Finance will retreat from his proposal to tax income trusts.
It is also unlikely that they will fully recover in value to their pre-Oct. 31 levels if their cash flow does not increase because of the proposed distribution tax on them.
Hence, it may be wise to minimize the loss by claiming tax refunds and sharing the loss with the person who generated the loss in the first place.
Vern Krishna is tax counsel at Borden Ladner Gervais LLP and executive director of the CGA Tax Research Centre at the University of Ottawa. He may be reached at firstname.lastname@example.org