Avoid superficial losses
Avoid superficial losses
Last week, 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 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 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 IT387R2 - Meaning of Identical Properties . 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.
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 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.
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 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.
Seek professional help
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, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at email@example.com
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