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24.3.3 Capital Losses

Understand how capital losses are calculated, the rules for worthless and superficial losses, and their implications in Canadian tax law.

Overview

A capital loss occurs when a security is sold for less than its cost. Capital losses are calculated in the same manner as capital gains and can generally be deducted from capital gains. This chapter explains how capital losses are treated under Canadian tax law, including types of special capital losses such as worthless and superficial losses.

Calculation of Capital Losses

Example

Stanley sold shares in his bank stocks for a $5,250 capital gain. That same year, Stanley’s computer tech stocks dropped in value, and he sold the shares for a capital loss of $3,000. Normally, Stanley would pay tax on $2,625 of his capital gain ($5,250 gain × 50%), but he is permitted to deduct $1,500 of the allowable capital loss ($3,000 loss × 50%) from that amount. Because of this deduction, Stanley will pay tax on only $1,125 ($2,625 taxable capital gain – $1,500 allowable capital loss). Allowable capital losses that cannot be used in the tax year can generally be carried back three years or carried forward indefinitely to offset taxable capital gains in other years. However, allowable capital losses can only offset taxable capital gains and not other income.

Special Cases: Worthless Securities and Superficial Losses

Worthless Securities

When a security becomes worthless, the holder must complete a CRA form declaring the security worthless to realize the capital loss for tax purposes. This rule does not apply to instruments with an expiry date, such as warrants, rights, or options. For these instruments, investors can claim capital losses after they expire without a declaration. An exception occurs when a security becomes worthless due to the underlying company’s bankruptcy or insolvency. In these cases, the Income Tax Act deems the taxpayer to have disposed of the security for nil proceeds and reacquired it at a cost of nil.

Superficial Losses

A superficial loss happens when securities sold at a loss are repurchased within 30 calendar days before or after the sale and are still held at the end of 30 days after the original sale. Superficial losses are not deductible as capital losses. However, they may be deferred rather than lost entirely. The superficial loss rules prevent taxpayers from creating deductible capital losses without any meaningful change in ownership.

Example: Superficial Loss

Pierre buys 100 XYZ shares at $30 per share in mid-April and sells the shares at $25 per share on May 1. He incurs a $500 capital loss (calculated as $3,000 – $2,500). Typically, an allowable capital loss of $250 (50% of $500) would be deductible against taxable capital gains. However, the superficial loss rule applies in the following scenarios: Scenario 1:

  • On May 15, Pierre reacquires 100 XYZ shares at close to $25 per share and holds them until July.
  • Since the transaction was within 30 days after the May 1 sale and shares were held for 30 days post-disposition, the loss is considered superficial. Scenario 2:
  • On April 29, Pierre acquires 100 XYZ shares near the initial $30 per share purchase price.
  • He sells 100 XYZ shares on May 1 at $25 per share but still holds 100 shares until July.
  • The loss is also considered superficial as shares were acquired less than 30 days before the sale and held for at least 30 days post-disposition. Superficial loss rules apply not only to the investor but also to the following related parties:
  • The investor’s spouse or common-law partner
  • Corporations controlled by the investor or spouse
  • A trust in which the investor is a majority interest beneficiary Superficial losses are non-deductible but can be added to the cost base of repurchased shares, thereby reducing future capital gains.

Example of Superficial Loss

Using the previous example, if Pierre’s $500 capital loss was superficial, and he reacquired the shares at $25 per share before May 31, the $5 per share loss would add to the cost base of the 100 shares owned on May 31. If these shares sell later at $40 per share, the capital gain calculation is:

  • \(\text{Proceeds from disposition} = 100 \times 40 = 4,000 \)
  • \(\text{Less: Cost of repurchasing shares} = 100 \times 25 = 2,500 \)
  • \(\text{Superficial loss} = 100 \times 5 = 500 \)
  • \(\text{Commission on purchase} = 45\)
  • \(\text{Subtotal} = 955 \)
  • \(\text{Less: Commission on sale} = 60 \)
  • \(\text{Capital gain} = 895 \)
  • \(\text{Taxable capital gain} (50% of 895) = 447.50\)

Exceptions to Superficial Loss Rules

Superficial loss rules do not apply in the following circumstances:

  • The investor emigrates from Canada
  • The investor dies
  • An option expires
  • A deemed disposition of securities by a trust occurs
  • The securities are sold to a controlled corporation

Key Takeaways

  • Capital losses occur when securities are sold for less than their adjusted cost base (ACB).
  • Allowable capital losses can offset taxable capital gains and can be carried back three years or forward indefinitely.
  • Superficial losses, arising from repurchased securities within 30 days, are non-deductible but can be deferred.
  • Worthless securities can realize capital losses with a CRA declaration.

For more details, consult the Canadian Revenue Agency (CRA) and the Canadian Securities Institute websites."

📚✨ Quiz Time! ✨📚

🧐 Assess and Solidify Your Understanding

Welcome to the Knowledge Checkpoint! You’ll find 10 carefully curated quizzes designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you’re on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck! 🍀💪

markdown ## What is a capital loss? - [ ] When a security is sold for more than its cost - [x] When a security is sold for less than its cost - [ ] When a security is sold at its original cost - [ ] When a security is repurchased within 30 days > **Explanation:** A capital loss occurs when a security is sold for less than its cost. This type of loss can be deducted from capital gains. ## How can allowable capital losses be used? - [x] They can be used to offset taxable capital gains - [ ] They can be used to offset all types of income - [ ] They cannot be used at all - [ ] They must be claimed within the same tax year > **Explanation:** Allowable capital losses can only be used to offset taxable capital gains and can be carried back three years or forward indefinitely. ## What must an investor do to declare a worthless security for tax purposes? - [x] Fill out a CRA form electing to declare the security worthless - [ ] Sell the security to another investor - [ ] Do nothing, it will be automatically declared - [ ] Reacquire the security after 30 days > **Explanation:** When a security becomes worthless, the security holder must fill out a CRA form electing to declare it worthless to realize a capital loss for tax purposes. ## What conditions lead to a superficial loss? - [ ] When securities sold at a loss are repurchased within 60 calendar days - [ ] When securities are sold for any profit - [x] When securities sold at a loss are repurchased within 30 calendar days - [ ] When securities are donated to charity > **Explanation:** A superficial loss occurs when securities sold at a loss are repurchased within 30 calendar days before or after the sale and are still owned 30 calendar days after the original sale. ## Are superficial losses tax-deductible as a capital loss? - [ ] Yes, they are always tax-deductible - [ ] Yes, but only if repurchased within 60 days - [x] No, they are not tax-deductible as a capital loss - [ ] No, but they can offset other types of income > **Explanation:** Superficial losses are not tax-deductible as a capital loss, though the tax advantage may be deferred. ## Who else besides the investor can be involved in superficial loss conditions? - [ ] Only other individual investors - [x] The investor’s spouse or common-law partner, corporations controlled by the investor or spouse, and a trust in which the investor is a majority interest beneficiary - [ ] Financial institutions where the investor has accounts - [ ] The Canadian government > **Explanation:** Superficial loss rules apply not only to the investor but also to their spouse or common-law partner, corporations controlled by them, or a trust in which they have a majority interest. ## What happens to a superficial loss? - [ ] It is completely lost forever - [ ] It can be immediately deducted against regular income - [x] The amount of the loss is added to the cost of the repurchased shares - [ ] It is doubled and applied to capital gains > **Explanation:** The amount of a superficial loss is added to the cost of the repurchased shares, reducing the ultimate capital gain for tax purposes. ## What happens when a security becomes worthless due to the underlying company’s bankruptcy? - [x] The taxpayer is deemed to have disposed of the security for nil proceeds and reacquired it at a cost of nil - [ ] The taxpayer automatically receives a tax credit - [ ] The security must be physically destroyed - [ ] The taxpayer must carry forward the loss indefinitely > **Explanation:** When a security becomes worthless due to bankruptcy, the Income Tax Act deems the taxpayer to have disposed of the security for nil proceeds and reacquired it at a cost of nil. ## Which of the following is NOT a condition that exempts the superficial loss rule? - [ ] The investor emigrates from Canada - [ ] The investor dies - [x] The investor separates from a spouse or common-law partner - [ ] An option expires > **Explanation:** The rules regarding superficial losses do not apply when an investor separates from a spouse or common-law partner unless specified otherwise in other tax conditions. ## What is used to calculate the allowable capital loss? - [ ] Original purchase price and current income - [ ] Date of purchase only - [x] 50% of the capital loss amount - [ ] The investor’s annual income > **Explanation:** Allowable capital losses are calculated as 50% of the capital loss amount.

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Saturday, July 13, 2024