Page 1 A Time for Change? Digging beneath the surface of the superficial loss rules Final paper Marissa Verskin
Page 2 ABSTRACT The superficial loss rule seeks to deny the immediate tax benefit of capital losses realized upon a transfer of property, where the property is effectively retained either personally or through the holdings of an affiliated person. Such transactions are considered to be artificial. This paper provides an in­depth discussion of the rule. It demonstrates that the rule is theoretically necessary from a policy perspective. It is also practically necessary because, as illustrated by the US experience and Finnish data, taxpayers undertake artificial transactions to obtain tax benefits in spite of associated costs. An analysis of the legislation questions whether artificial transactions are appropriately identified, focusing on the main components of the rule: the 30 day threshold and the notion of “identical property”. The suitability of the former is questioned, for example from the perspective of market volatility; the latter is discussed using principles of statutory interpretation, and considering CRA’s interpretation. It is shown that knowledgeable taxpayers easily circumvent the rule, that unreported transactions may be difficult for CRA to identify, and that “true” transactions undertaken by the unwary may be inappropriately captured. Where an RRSP is involved, a “true” transaction may result in a permanent loss denial. The rule is compared to each of the US, UK, and Australian approaches, and appears to have been drafted to favour simplicity over equity. However, the rule’s application is not necessarily simple and can be inequitable. It is concluded that the rule is a trap for the unwary, unknowledgeable, and unlucky, and does not achieve its legislative intent. Suggestions for legislative consideration are made. INTRODUCTION The superficial loss rule denies the immediate use of capital losses realized upon a transfer of property, where the same (or identical) property is acquired 30 days before or after the sale by the person or an affiliated person. Such a transaction is considered to be artificial. The superficial loss rule has been the subject of sharp criticism, yet has essentially remained unchanged since its introduction in 1971. Notably, the Carter Commission cautioned that the U.S. experience demonstrated that “regulations to prevent this type of artificial realization only lead to more complex manipulations.” 1 In spite of this warning, the superficial loss legislation was introduced. Grover, in writing about the superficial loss rule shortly after its introduction, described the rule as a “trap for the unwary, especially if literally applied, as opposed to being a true deterrent to recognizing accrued and unrealized capital losses”. 2 He analyzed the rule, beginning with a brief history and a discussion of its legislative intent. He also briefly described the rule, its exceptions, its general application, and several ways in which it could be circumvented. Grover identified a possible legislative glitch in the wording, an issue that has, since Grover’s time of writing, been administratively addressed as will be discussed. Grover ends with a discussion of several tax 1 Canada, Department of Finance, Report of the Royal Commission on Taxation (Ottawa: Department of Finance 1966) vol. 3, at 367. 2 Warren Grover, “Superficial Losses” (1974) vol. 22, no. 3 Canadian Tax Journal 253­259, at 259.
Page 3 planning opportunities that arise from the rule, concluding that while these may be interesting, the benefit to the tax system of the rule is difficult to determine. This paper analyzes the superficial loss rule in more detail. Unlike Grover’s article, tax planning opportunities are not explicitly addressed, though they are implied through the analysis. Also unlike Grover’s article, after providing an overview of the legislation, the theoretical and practical necessity of the rule is discussed to determine whether the rule has any legislative place whatsoever. The rule is considered in the context of the general scheme of individual unit taxation that is present throughout the Act, and is contrasted with other rules concerning transfers between spouses. It is shown that the rule is theoretically necessary as an anti­avoidance provision to prevent artificial transactions from resulting in a tax benefit, a situation that is offensive to tax policy. However, because costs must generally be incurred to artificially trigger a loss, and because the benefit to the taxpayer is generally only the time value of money, whether taxpayers in fact create superficial losses is questioned. Considering the US experience 3 and Finnish data, it is shown that taxpayers do trigger their losses through artificial transactions in spite of the associated costs of doing so. While the extent of the tax base erosion cannot be quantified due to a lack of data, the available data suggest that the erosion is potentially significant, particularly in times of economic turmoil, such that a superficial loss rule is a necessary piece of legislation. After concluding that the legislation is necessary, a detailed analysis of the legislation is provided to determine whether artificial transactions are appropriately identified. Based on the structure of the rule which relies heavily on the 30 day period and the notion of “identical property”, it is shown that the rule may not accurately identify artificial transactions. Furthermore, the rule applies only to “affiliated persons” such that transfers to, for example, adult children or friends would not be affected. Consequently, knowledgeable taxpayers (particularly those with well­developed social networks) can easily circumvent the rule with the result that the rule is rendered ineffective. Each of the two key elements of the definition of a superficial loss is addressed in detail. The 30 day threshold was likely borrowed from US legislation which was itself arbitrarily determined by US Senators in 1921. While Grover questioned the reason for the selection of the 30 day period, he left this question unanswered and discussed this period only in terms of how the rule was to be applied. This paper discusses the possible economic impact of the 30 day period as well as its possible lack of continuing suitability, for example from the perspective of market volatility. The second key element of the definition, the notion of “identical property”, was identified by Grover as being a legislatively undefined term that is administratively defined by Canada Revenue Agency (CRA). This paper broadens the discussion by analyzing the meaning of the word using basic principles of statutory interpretation. It concludes that the term creates uncertainty as to the nature of property captured by the rule. If “identical property” is interpreted literally, as opposed to as interpreted by CRA, very few properties would be identical, with the result that fewer sale and repurchase transactions would fall within the reach of the superficial loss rule than was perhaps intended. 3 Department of Finance, supra note 1.
Page 4 While the rule clearly captures some artificial transactions, it is shown that it also captures many transactions that should not be considered artificial at all. In fact, though not considered by Grover, where a Registered Retirement Savings Plan (RRSP) is involved, a genuine transaction may have the harsh result that a loss is permanently (as opposed to only temporarily) denied. Furthermore, since the rule is easily avoided, knowledgeable taxpayers may easily circumvent the rule without penalty, leaving only blatant violators and those that are unwary within its reach. Because the unwary and unknowledgeable will fail to report superficial losses, they may only be caught in the event of a CRA audit. Furthermore, failure to report such losses may result in the application of preparer penalties. Detection of superficial losses may be difficult and could require a costly review of a large volume of additional information that is not included in tax returns. Such a process would likely result in relatively less tax revenue than other audit avenues, with the result that superficial losses are generally unlikely to be identified by CRA. Compliance issues and the potential application of preparer penalties were not considered by Grover. Consequently, while Grover termed the superficial loss rule a “trap for the unwary” 4 , it is perhaps better termed a trap for the unwary, unknowledgeable, and unlucky. Finally, unlike Grover’s article which addresses the Canadian and to some extent the US legislation, the Canadian approach is compared to that of the U.S, U.K., and Australia. It is suggested that there is a spectrum of possible approaches that ranges from a legislated threshold that defines artificial transactions at the one end, to a General Anti­Avoidance Rule (GAAR) based approach at the other. This spectrum illustrates the theoretical trade­off between administrative simplicity and greater accuracy in identifying artificial transactions. Based on the structure of the Canadian rule, it is suggested that it was selected to favour administrative simplicity over greater equity. However, it is shown that the application of the rule is not necessarily simple, and may be quite inequitable. Suggestions for legislative consideration are made. 4 Grover, supra note 2.
Page 5 Table of Contents OVERVIEW OF THE LEGISLATION ........................................................................................... 6 Main legislation................................................................................................................. 6 Notes regarding additional legislation ................................................................................... 6 LEGISLATIVE INTENT ........................................................................................................... 7 Theoretical Necessity for the Superficial Loss Rule .................................................................. 7 Taxation of Capital Gains ................................................................................................. 7 Whether a disposition between spouses should be denied...................................................... 9 Support for the Practical Necessity of the Superficial Loss Rule. ...............................................11 TECHNICAL OVERVIEW OF THE SUPERFICIAL LOSS RULE AND DEFINITIONS................................14 Legislatively Defined Components of the Superficial Loss Rule...............................................14 Legislatively Undefined Components of the Superficial Loss Rule............................................16 COMPLIANCE ISSUES ..........................................................................................................19 CRA Audit .......................................................................................................................19 Preparer penalties............................................................................................................20 Possible resolution ...........................................................................................................21 WHETHER THE POLICY INTENT IS APPROPRIATE AND IS ACHIEVED ............................................21 Superficial losses may be unintentional................................................................................21 Superficial losses and the RRSP ..........................................................................................22 Completeness of the superficial loss rule ..............................................................................23 Means of Denying the Loss ................................................................................................24 Discussion of the 30 Day Rule .........................................................................................24 INTERNATIONAL EXPERIENCE...............................................................................................28 United States ..................................................................................................................28 UK.................................................................................................................................29 Australia.........................................................................................................................30 Finland...........................................................................................................................31 Conclusions that can be drawn from the international experience .............................................31 CONCLUSION AND SUGGESTIONS FOR REVISION....................................................................33 BIBLIOGRAPHY...................................................................................................................35 COMMENTS FROM THE MEDIUM PAPER.......................................... Error! Bookmark not defined.
Page 6 OVERVIEW OF THE LEGISLATION Main legislation Subparagraph 40(2)(g)(i) of the Canadian Income Tax Act 5 deems any superficial loss of a taxpayer that arises out of a disposition of property to be nil. This denial relies on several important definitions: “taxpayer”, “property”, “disposition”, “affiliated”, and “superficial”, each of which is discussed in the Definitions section of this paper. The calculation of a loss from the disposition of any property is specified by paragraph 40(1)(b) to be the difference between the proceeds of disposition, and the total of the taxpayer’s adjusted cost base (“ACB”) and costs incurred in respect of the disposition. Any superficial loss denied is added to the taxpayer’s ACB of the property pursuant to subsection 53(1)(f). The loss is therefore generally only denied on a temporary basis as it is captured in the taxpayer’s ACB. For example, if the property is subsequently sold to a third party, the loss will effectively be realized at that point through an increase in the amount of the loss (or reduction in the gain) that would otherwise have arisen in absence of the adjustment pursuant to subsection 53(1)(f). 6 Notes regarding additional legislation It is noted that where the stop­loss rules contained in subsection 40(3.4) are applicable, the transaction is specifically excluded from the superficial loss rule as defined in section 54. Subsection 40(3.4) generally applies to certain transfers from a corporation, trust, or partnership that trigger a capital loss, where the property (or identical property) is held 30 days before or after the disposition by the transferor or a person affiliated with the transferor. Subsection 40(3.4) and associated provisions 7 generally parallel the superficial loss rule, with the main difference generally being that these provisions suspend the loss with the transferor, while the superficial loss rule generally results in the loss being suspended with the transferee. Due to the structure of the legislation, transfers from a corporation, trust, or partnership that result in a capital loss will generally fall within the jurisdiction of subsection 40(3.4), and not the superficial loss rule. Thus these transactions, as well as the various other stop­loss rules 8 , are 5 RSC 1985, c.1 (5 th Supp.), as amended (herein referred to as “the Act”). Unless otherwise stated, statutory references in this article are to the Act. 6 For a discussion of the application of the superficial loss rules, see for example Canadian Tax Reporter Commentary (North York, ON: CCH Canadian)(online), paragraphs 6434a and 6434ac. See also Canada Revenue Agency, “What is a Superficial Loss?” (online: http://www.cra­ arc.gc.ca/tx/ndvdls/tpcs/ncm­tx/rtrn/cmpltng/rprtng­ncm/lns101­170/127/lss­ddct/sprfcl/menu­ eng.html ) and Howard J. Kellough and Peter E. McQuillan, Taxation of Private Corporations and Their Shareholders, 4 th ed. (Toronto: Canadian Tax Foundation, as yet unpublished). 7 The conditions under which subsection 40(3.4) of the Act will apply are set out in subsection 40(3.3) of the Act. 8 Other stop­loss rules include, for example, subsections 40(3.6) and 40(3.7).
Page 7 beyond the scope of this paper which will focus on the superficial loss rule. It is noted, however, that due to the similarity between the rules, many comments made in this paper may be equally applicable to those other provisions. Any revisions made to the superficial loss rule should also be considered with regard to these other provisions to ensure consistency across the stop loss legislation. LEGISLATIVE INTENT Before delving into the technical detail of the superficial loss rule, it is helpful to understand its intended purpose, and how it fits within the overall scheme of the Act. The purpose of the superficial loss rule is to prevent an artificial transaction between certain parties from generating in a tax benefit—i.e. an allowable capital loss that could shelter a taxable capital gain. 9 However, such “artificial” transactions may occur at fair market value (FMV), and may involve a change in beneficial ownership. Thus it may seem unfair that the legislation denies the loss for tax purposes where the facts indicate that it has been suffered. There is no parallel legislation to deny “artificial” transactions that trigger capital gains. On the basis of this preliminary discussion, the superficial loss rule may seem illogical when viewed in isolation. It is helpful to consider the rule in the larger context of the taxation of capital gains to better understand its legislative intent. In this context, it is apparent that the rule was introduced at the same time as the capital gains taxation regime to address certain concerns that arose from that regime. It is also helpful to consider the basic structure of the taxation system, i.e. that it is based upon individual (as opposed to family unit) taxation. Theoretical Necessity for the Superficial Loss Rule Taxation of Capital Gains The capital gains taxation regime was introduced in 1971. Initial proposals attempted to tax certain capital gains on an accrual basis but, due to overwhelming condemnation by taxpayers 10 , the final legislation taxed only realized capital gains. 11 Because taxpayers control the timing of the realization of capital gains and hence their taxation, this legislation could be subject to manipulation by taxpayers who could “cherry pick” to defer the realization of capital gains and hasten the realization of capital losses. One such manipulation is the creation of artificial transactions to realize losses prior to their true disposition in order to shelter realized capital gains. It is this manipulation that the superficial loss rule attempts to prevent. One might think that if a loss of value has truly occurred, the taxpayer should be allowed to claim it. If this is the case, so long as transactions occur at fair market value, the superficial loss 9 CCH Editors, Explanation of Canadian Tax Reform (CCH Canadian Limited, 1972), pages 54­ 55. See also Canadian Tax Reporter Commentary (North York, ON: CCH Canadian)(online), paragraphs 6434a and 6434ac. Canada, Respecting the White Paper on Tax Reform, 18 th report of the Standing Committee of Finance, Trade and Economic Affairs, 28 th parliament, 2 nd session, October 1970, 31­32. 10 11 Canada, Department of Finance, 1971 Budget, Budget speech, Friday June 18, 1971, 12.
Page 8 rule is inappropriate because it denies the economic reality of a decline in value. However, the same logic would require that accrued gains attract taxation; this is not the case in a world of realization based taxation. In the absence of a superficial loss rule, taxpayers may essentially obtain realization­based taxation for accrued gains, but accrual­based taxation (to the extent that there are other realized capital gains available for off­set) for accrued losses through the use of artificial transactions. This is harmful to the tax base as taxpayers have the benefit of paying tax on accrued gains only once they dispose of the property; similarly, taxpayers should only have the benefit of claiming capital losses when they dispose of the property. Artificial transactions may further erode the tax base as taxpayers may take advantage of what they perceive to be temporary market declines, and this may question whether the transaction is at a true fair market value. To illustrate, assume Mr. A purchases a stock for $100. The market value declines to $50, which he believes to be temporary. He thus sells the stock, and immediately repurchases it. The value of the security increases shortly thereafter, as he expected, to $110. In absence of the superficial loss rule, Mr. A could have realized a capital loss (and sheltered other capital gains) of $50, and would now hold a security with cost base of $50, and an accrued (untaxed) gain of $60 (i.e. the $110 fair market value less the cost base of $50). However, Mr. A would never have sold the security for $50 as he was confident that the value would increase. Thus although the apparent fair market value is $50, it is not a “true” fair market value as in a “true transaction”, Mr. A would never have sold at this price. It is impossible to prove that this is not fair market value as the transaction seemingly occurred between arm’s length parties on an open market. However, because of the lack of substance of the transaction, and all other things being equal, it may be questionable that a true arm’s length price was negotiated. And this illustrates that identifying artificial transactions is not always an easy task and cannot necessarily be objectively accomplished. The Carter Commission report does not appear to specifically address the superficial loss rule. It simply notes that transactions with non­arm’s length persons should be adjusted to reflect FMV, and should be tested for reasonableness. 12 It suggests that where people are taxed as individuals, there should be certain restrictions. 13 No detail is provided as to what these “certain restrictions” should be, though this could be construed as a veiled reference to some form of superficial loss rule. 14 Clearly, “cherry picking” could be of concern, but it may be difficult to distinguish those transactions that attempt to “cherry pick” from those that are “true”. In fact, the commission cautioned that the US experience has demonstrated that “regulations to prevent this type of artificial realization only lead to more complex manipulations.” 15 In spite of this cautionary note, Parliament adopted the superficial loss rule. 12 Department of Finance, supra note 1, at 111, paragraph 35. 13 Ibid, 110 at paragraph 23. 14 Ibid, at 367. 15 Ibid, at 367.
Page 9 Whether a disposition between spouses should be denied An important aspect of the loss denial hinges on the existence of a special relationship (for example spouses) between the parties involved 16 . In an effort to determine whether this parameter is appropriate, it is helpful to consider several examples. As a first example, take the case of a sale of publicly traded shares to an arm’s length individual for FMV consideration. Such an event is clearly a realization because the exchange is at FMV and there has been a substantive change in ownership. It is difficult to argue that such an event should not be a realization for tax purposes. By contrast, take the case of a sale of publicly traded shares to a spouse for FMV consideration. In this case too, the exchange is at FMV and there has been a substantive change in ownership. The distinction between the two cases is simply that in the second the parties to the transaction are spouses. Should this matter from a policy perspective? Since spouses belong to the same family unit which operates as a single unit for economic purposes, has there been a substantive change in economic ownership? If the transfer occurs at FMV, does economic ownership matter from a policy perspective? Or is the concern here that only losses will be triggered? The Act appears to indicate that there has in fact been a change in beneficial ownership or such a transaction would not be a disposition in the first place as defined in subsection 248(1). Clearly, there may be a disposition as gains may be triggered in this fashion. The concern appears to be that the asset remains in a close family group which questions whether there was a disposition. Theoretically, this should be captured within the definition of “disposition” itself. However, perhaps the superficial loss rule is necessary for greater certainty as it may be difficult to establish whether there has been a change in beneficial ownership. For example, if a matrimonial home is transferred from husband to wife and both continue to live in it, it may be clear that there has been no change in beneficial ownership and hence no disposition pursuant to subsection 248(1). By contrast, if the asset is a security, it may be more difficult to show that there has been no change in beneficial ownership; on the one hand the asset belongs to the same family group, but on the other it is owned by different people within that group who may use it for their own personal benefit as opposed to for the benefit of the family unit. The superficial loss rule appears to inherently deny the existence of any such disposition for the purposes of claiming a loss, thereby removing the need to determine whether there has been a change in beneficial ownership. This has the advantage of simplicity, but also treats the family unit (instead of the individual) as the unit of taxation. Such treatment is contrary to the general scheme of the act which is generally based on individual taxation. The question then becomes one of whether this treatment is justifiable. 16 This “special relationship” is in fact affiliation as defined in subsection 251.1(1). This definition is described in detail in the Definitions section of this paper. Importantly, an individual is affiliated with himself, his spouse, a corporation controlled by him or his spouse, a partnership of which he is the majority interest partner, and a trust of which he is a majority interest beneficiary.
Page 10 Although the Canadian taxation system generally treats the individual as the unit that attracts taxation, special rules exist (such as those applicable to transfers between spouses) to recognize that there is a special relationship between certain family members. Inter­spousal transfers are generally eligible for rollover treatment unless the spouses elect out of these provisions. Rules such as these are more consistent with family­unit taxation. However, in spite of the existence of rollover provisions, and possibly in order to maintain the integrity of the individual­based taxation system, complex attribution rules exist. These rules ensure that where such a transfer occurs, FMV consideration is received (for example), or income is attributed back to the transferor. Notably, while these attribution rules mitigate the benefit of rolling a property from one spouse to the other, no such mitigation of the cost to the taxpayer of not being able to immediately recognize a superficial loss is provided. While the superficial loss rule is somewhat consistent with the rollover provision that permits there to be no gain on transfers between spouses, both are more consistent with family unit taxation. Unlike the rollover legislation however, there is no way to elect out of the superficial loss rule. Furthermore, both pieces of legislation result in the accrued gain (or loss) potentially being moved to the transferee so that it is taxed/realized in his/her hands. Again, this is inconsistent with individual taxation as it taxes in one spouse’s hands the gain or loss of the other. However, movement of the loss with the security is theoretically simpler for individual taxpayers to track such that the legislation has perhaps sacrificed consistency for taxpayer convenience. At first glance, it seems curious that there would be a provision allowing spousal rollovers to occur at fair market value as opposed to cost, and that this may pave the way for tax avoidance transactions. However, the system is generally an individual­based taxation system such that transfers should generally be at FMV. Thus the option to opt out of the rollover is consistent with individual­based taxation, while the rollover is an exception to this as it is consistent with family unit­based taxation. Because of the presence of the superficial loss rule, opting out of the rollover cannot result in an allowable capital loss; it can only result in a taxable capital gain. Spouses would presumably only want to elect out in special circumstances such as to allow capital losses to be claimed. It is thus difficult to see this provision as one that enables tax avoidance. Rather, it seems that the ability to opt out is present to provide some measure of consistency with the individual unit­based taxation system. Based on this discussion, the legislation appears to be neither wholly consistent with individual­ based taxation, nor family unit­based taxation. What is reasonably clear, however, is that the legislation is determined to curtail those transactions that could benefit an individual because of a special family relationship in the presence of individual unit taxation. In other words, from a policy perspective, there is a need to deviate from the system of individual unit taxation to prevent tax avoidance. This, in turn, raises the question of whether such a transaction is in fact tax avoidance. Since the superficial loss rule parallels the result that would occur in a world of family­unit taxation (i.e. no loss would be realized upon the transfer), it is helpful to consider the rationale for family unit­based taxation. The Carter Commission indicates that the family unit, not the individual, should be taxed as the appropriate measure of ability to pay, and that transfers from one family member to another should be tax free. The report states that no disposition should be considered to have occurred where, for example, there is “no change in the essential continuity
Page 11 of an investment, although there may have been some alteration in the form of the investment.” 17 Presumably this commentary could be extended to other transactions that give rise to a superficial loss involving affiliated corporations, etc. So long as family unit taxation was in effect, there would be no need for the spousal rollover provision, the superficial loss rule, and anti­income splitting measures. However, since the system is based on individual taxation, fair market value sales between any parties are not necessarily tax avoidance transactions and would be expected to attract tax consequences. It would seem that parliament is trying to “have its cake and eat it too” by benefitting from the perceived merits of the individual­based system (including the prevention of income splitting) with some concessions such as for spousal rollovers, while at the same time introducing provisions to prevent taxpayers (who are perhaps better represented by a family unit) from engaging in transactions that could allow them to benefit from the individual­based system. Whether a family­unit based taxation system should be considered by Canadian legislators is a topic that is beyond the scope of this paper. Because the current system requires individual taxation even where family unit taxation may perhaps be a truer representation of a taxpayer’s situation, steps must be taken to prevent taxpayers from exploiting the system and causing an erosion of the tax base. Consequently, the superficial loss rule is justifiable as an anti­avoidance measure. Support for the Practical Necessity of the Superficial Loss Rule. As can be seen, there is a theoretical necessity for a superficial loss rule as an anti­avoidance measure. This implicitly assumes that it is financially beneficial for a taxpayer, in the absence of a superficial loss rule, to engage in artificial transactions that will create an immediate tax loss that can shelter other capital gains. It also assumes that taxpayers are willing to sell securities (if only artificially) at a loss. However, this sale of loss securities may contradict the disposition effect, a phenomenon in which taxpayers are loath to part with securities that have accrued losses 18 . On the other hand, since a superficial loss arises from an artificial transaction, there has been no “real disposition” with the result that the disposition effect may not off­set the tendency to realize superficial losses at all. This disposition effect, together with all other factors, must be considered in any analysis of whether superficial losses are of benefit to taxpayers. Other factors include the presence of transaction costs (such as brokerage fees) that reduce the benefit otherwise obtained. 19 These factors to some extent serve as a natural deterrent to artificially triggering tax losses. It must therefore be determined whether superficial losses are actually beneficial to taxpayers considering that realization is not without a downside. If they are not beneficial, taxpayers will not engage in artificial transactions, and consequently there is no need for a superficial loss rule at all. 17 Department of Finance, supra note 1, at 122, 142­143, and 370. 18 Mark Grinblatt and Matti Keloharju, ‘‘Tax Loss Trading and Wash Sales’’ (2004) vol. 71, Journal of Financial Economics 51­76, 52. 19 See D.Y. Timbrell, “A Note on Non­Superficial Losses” (1972) vol. 20, no. 5 Canadian Tax Journal 430­432.
Page 12 Except where an RRSP is involved as discussed below, the benefit of realizing and using a “superficial loss” would generally be a timing difference (plus any difference due to changing tax rates) because the tax benefit may be claimed immediately as opposed to at a future point when there is a “true” disposition. Due to the time value of money, and particularly where future tax rates are expected to be lower, this may be of substantial value. D.Y. Timbrell calculates when it is beneficial to sell and repurchase loss securities, and concludes that because of transaction costs, such a transaction is rarely beneficial. This means that the benefit of obtaining a tax benefit now as opposed to at a future point is almost always outweighed by the cost of creating a transaction to obtain this benefit. He also calculates an inverse relationship between the amount of the loss, and the length of time that the reacquired security must be held (assuming a certain rate of annual return) in order for the overall transaction to be worthwhile. In other words, the larger the loss, the shorter the period of time required for holding the repurchased security. 20 While this is logical in theory, taxpayers may devise means of reducing transaction costs, or arranging for lower cost side arrangements to transfer securities to a spouse. Furthermore, taxpayers may make different assumptions as to interest rates, future tax rates, growth rates, etc., than Timbrell which may result in them forecasting net benefits in spite of the associated costs. Similarly, taxpayers may have different preferences as to the time value of money such that some would rather shelter other capital gains today (and hence have additional cash in hand), even if this means that they must pay additional transaction costs. In absence of actual Canadian data, it is difficult to quantify the number of superficial loss transactions that would occur in Canada in the absence of the superficial loss rule, nor the quantum of the resulting loss in tax revenue. This is made more difficult by the fact that there may be no absolute loss in tax revenue as the difference is generally one of timing; measurement would require a calculation of the time value of money between the date of the artificial and “real” realization transactions. Clearly, Canadian data sufficient to calculate this is unavailable. Although there is insufficient Canadian data, the Finnish experience provides some insight into the extent to which superficial losses would be triggered in the absence of the superficial loss rule. In Finland there are no "wash sale rules" (i.e. a rule similar to the Canadian superficial loss rule), and although there is an anti­avoidance provision that could deny tax­motivated transactions, this rule has never been applied to wash sales. The Finnish experience is therefore of interest as analysis of the stock trading patterns of Finnish households provides evidence as to whether taxpayers do in fact wish to trigger superficial losses. Grinblatt and Keloharju analyze the period around year­end, and prove that there is an increase in the sale of loss securities and repurchase either on the same day, or within 25 days. 21 No justification is provided for selecting 25 days as the time period of interest; however, it is interestingly close to the 30 day threshold in the Canadian (and US equivalent) superficial loss rule. Specifically, Grinblatt and Keloharju take the number of stocks with realized losses divided by the sum of the number of stocks with realized losses and the number of stocks with paper losses. 20 Ibid. 21 Grinblatt and Keloharju, supra note 18.
Page 13 A similar calculation is performed for stocks with accrued and realized gains. Using this calculation, it is shown that there is a greater propensity to realize losses at year­end, particularly within the last week of the year, a period for which this percentage is 17.7%. By contrast, this percentage is only 11.9% for the 25 day period after year­end. This pattern is consistent with taxpayers selling securities with accrued losses in order to utilize the resulting capital loss before the end of the taxation year. 22 Where the losses realized are in excess of 30%, the rate of repurchase is relatively high (17.2%) while the rate of repurchase for mild capital losses is much lower (11.7%), and the rate of repurchase for stocks with capital gains is even lower (9.9%). The authors conclude that these differences are significant. The data indicates that more losses are realized within the last month (and particularly the last week) of the year, and that where these losses are large, there is an increased propensity to repurchase. Interestingly, the incidence of repurchase of stocks with accrued capital gains indicates that stock repurchases may often be for non­tax reasons. The decision to repurchase is presumably dependent on factors such as transaction costs as discussed earlier, whether the taxpayer does in fact wish to retain the security, and whether the outlook for the security has changed. The combined effect of the increased sales of loss securities together with the increased incidence of repurchase where the accrued loss is large may mean a significant tax revenue loss. However, in the absence of data, the revenue loss unfortunately cannot be quantified. On the basis of this information one may conclude that where the economy is relatively stable, superficial losses may not be much of a policy issue, particularly where there are other natural deterrents such as transaction costs. However, in times of economic decline where losses of 30% (or more) are common, it is suggested that more taxpayers would artificially realize losses with the result that superficial losses are more of a concern. In light of the volatility in current day markets and the real possibility of very large losses, the current environment is an example of one in which superficial losses should be of concern. The quantum of the revenue loss is perhaps a topic for future papers to explore. Grinblatt and Keloharju note that superficial losses occur less for corporations in Finland. They suggest that this is because in Finland, accounting and tax income are very similar; corporations have other (less costly) methods to reduce their taxable income such as by claiming additional amortization. Similarly, since accounting and tax income are very similar, triggering losses means reducing book income and thus appearing less profitable. Grinblatt and Keloharju also suggest that there may be less need to trigger superficial losses around year­end due to the increased trading frequency of institutions versus individuals. 23 One might surmise from this that in Canada, if the superficial loss rule was repealed, the incidence of superficial losses may be higher than in Finland, as it is more difficult to manipulate taxable income in Canada due to stricter accounting standards and more stringent tax legislation. Thus there would be an incentive for both individuals and corporations to trigger superficial losses. 22 Ibid, at 60­61. 23 Ibid, at 55 and 65.
Page 14 The increased incidence of transactions that give rise to large superficial losses around year­end in Finland suggests that there is a benefit to triggering these losses, at least under certain circumstances. The Finnish study does not indicate what these circumstances are, but it is suggested that these factors include the expected holding period of the stock after repurchase, expected tax rates, etc. Furthermore, it suggests that where superficial losses are denied, there is an incentive to circumvent the rules. For example, in Canada, this might entail selling stock of a company in a particular industry at a loss, and purchasing stock of a different company in the same industry. This would not result in a denial of the loss as the securities are not considered to be identical, though the taxpayer may feel that he is economically in a very similar position and is in fact indifferent between stocks. 24 It would be interesting to see whether there is an increase in trading activity towards the end of the year across similar (as opposed to identical) securities in Canada. Comparing this to the Finnish data may provide insight into the extent to which Canadians attempt to circumvent the rule. The lack of accurate trading data for Canada unfortunately precludes such an analysis. In spite of the lack of Canadian data it would seem reasonable to conclude that in the absence of the superficial loss rule, the incidence of artificial transactions would be high. This is on the basis of the Finnish experience, the presence of transactions that attempt to circumvent the rules, the number of countries that have expressed a similar concern (discussed below), and the amount of consideration given by taxpayers to triggering superficial losses. Such transactions would particularly occur where the loss was significant and there was an intention to hold the security for a long period of time. Based on the foregoing discussion, it would appear that a superficial loss rule is both theoretically and practically required to prevent a potentially costly deferral of the receipt of tax revenues. The next section describes the Canadian superficial loss rule legislation that seeks to prevent this deferral. TECHNICAL OVERVIEW OF THE SUPERFICIAL LOSS RULE AND DEFINITIONS 25 Legislatively Defined Components of the Superficial Loss Rule The definitions of the various terms used in the legislation are important as they serve to define the extent of the application of the superficial loss rule, and thus are a necessary starting point for any discussion of the rule. A taxpayer is defined in subsection 248(1) to include “any person whether or not liable to pay tax”. “Person” is also defined in subsection 248(1) and includes both natural persons and artificial persons (ex. corporations). A partnership is considered to be a person for the purposes of certain sections in the Act, such as the definition of affiliation (subsection 251.1(4)). Affiliation is discussed in more detail below. Property is defined in subsection 248(1) as (generally) meaning all property both tangible and intangible. Property includes a right and money. 24 Ibid, at 74. 25 Supra note 6.
Page 15 A disposition is defined in subsection 248(1). The definition is fairly complex, and includes those transactions that one would, based on the ordinary meaning of the word “disposition”, expect to be included. Such transactions include a sale or transfer of an asset. Specifically excluded (with exceptions with regard to certain transactions with trusts) from the definition of a disposition is a transfer of property where there has been no change in beneficial ownership. Affiliated persons are defined in subsection 251.1(1). Importantly, an individual is affiliated with: 1. His/her spouse 26 ; 2. A corporation controlled by the individual or his/her spouse; 3. A partnership of which the individual is a majority interest partner; and 4. A trust of which he/she (or an affiliated person such as a spouse) is a majority interest beneficiary. This would seem to cause an individual to be affiliated with his RRSP, TFSA, and RRIF 27 . Two corporations, two trusts, or two partnerships may also be affiliated with one another. However, because the stop­loss rules associated with such transfers are generally beyond the scope of this paper, this aspect of the affiliation definition has not been addressed. A superficial loss is defined in section 54 to generally be a taxpayer’s loss from the disposition of property where a property (that is the property, or an identical property) is owned by the taxpayer (or affiliated person) within 30 days before or after the date of the disposition, and at the end of this 60 day period the taxpayer (or affiliated person) owns (or has the right to acquire) the property (or identical property) 28 . Certain exceptions are outlined in this provision. While the details of these exceptions are beyond the scope of this paper, it would appear that, in general, these exceptions fall into two broad categories. The first serves to exclude from the superficial loss rules those transactions that are otherwise subject to another anti­avoidance provision in the Act. The second serves to exclude those transactions that are specifically mandated by the Act. The intent of the first category appears to be to prevent double counting of a disallowed amount, and also avoids confusion as to which provision is to take precedence. For example, these exceptions exclude dispositions of debt owed to related persons within a related group as this is already captured by paragraph 40(2)(e.1). The intent of the second category appears to be to enable certain other provisions to be fully (and fairly) implemented. For example, subsection 45(1) is one such provision that is excluded from the superficial loss rules. It is a “change in use” rule which generally causes a deemed disposition and reacquisition of a property upon a change in its use from business to personal or vice versa. For example, if Ms. A changes the use of her house from rental to personal, subsection 45(1) would deem her to have disposed of her house at FMV (resulting in a capital 26 In this paper, the term “spouse” will encapsulate both a spouse and a common law partner. 27 CRA document no. 2008­0299661E5, January 22, 2009. 28 Refer to Graphic Packaging Canada Corporation v. The Queen, 2001 DTC 861 (TCC) for an example of the application of this rule. In this case, the loss was not denied because the property, although reacquired, was not held at the end of the period.
Page 16 loss) and to have immediately reacquired it at FMV. Because Ms. A reacquires the house immediately, the reacquisition is by an affiliated person within 30 days of the sale. Because Ms. A retains the property, she will hold it at the end of the 30 day period. Consequently, the superficial loss rule would deny this loss, were it not for the fact that subsection 45(1) is specifically excluded from its application. This exclusion is necessary as without it, only capital gains would be realized upon a subsection 45(1) deemed disposition which would be inequitable, and would constrain the application of that provision. Thus this type of exclusion from the superficial loss rule is required to ensure that other provisions of the Act are fully and fairly implemented. Legislatively Undefined Components of the Superficial Loss Rule The superficial loss rule relies heavily on the 30­day time period, and on the notion of “identical property” in defining its scope. The 30­day time period requires no further definition, and is discussed from a policy perspective in more detail later in this paper. However, the notion of “identical property” requires additional discussion as its nature is unclear and it is not defined in the Act. The concept is administratively addressed by Canada Revenue Agency (“CRA”) in an interpretation bulletin 29 , which is discussed in more detail below. General principles of statutory interpretation suggest that where a term is not defined in the Act, the ordinary meaning of the word is the appropriate meaning. “Identical” is defined as “absolutely alike” or “one and the same”. 30 This definition suggests that changing any aspect of a property, however insignificant, would cause the properties to no longer be “absolutely alike” and hence no longer identical. Clearly, this would make it fairly easy to circumvent the rule as any tiny variation in the property would cause the properties to no longer be identical. It is interesting to take the analysis of the plain meaning of the word “identical” one step further. For example, assume that an individual, Mr. Z, purchases a share of Company X for $100. Company X deals exclusively in consumer electronics. The share underperforms and he sells it for $80, triggering a loss of $20. Two weeks later, Company X announces that it will dispose of its consumer electronics business, and will venture into the pharmaceutical industry. Mr. Z immediately purchases a share in Company X, which now costs him $85. It would appear that since Mr. Z has reacquired a share of Company X, the superficial loss rule would deny his $20 loss. However, when Mr. Z sold his share he sold an interest in a consumer electronics business; when he repurchased, he acquired an interest in a pharmaceutical company. Since “identical” means absolutely the same, it may be possible to argue that as the share is reflective of an ownership interest in the business, the fact that the business has completely changed would indicate that the original ownership interest is not identical to the ownership interest subsequently purchased. This would in turn indicate that the share repurchased is not identical to the original share sold. 29 Interpretation Bulletin IT­387R2, “Meaning of ‘Identical Properties’ (Consolidated)”, July 14, 1989. 30 Della Thompson,The Pocket Oxford Dictionary, 8th ed. (New York: Oxford University Press, 1992).
Page 17 Using a similar line of reasoning, one may be able to argue that any change in the business would cause shares to no longer be identical. The threshold of “identical” is very high, and since legislative wording is very carefully selected, it would seem that this is intentional. Furthermore, the Canadian legislation adopted the concept of a superficial loss as well as the 30 day threshold from the US, but chose not to adopt the U.S. threshold of “substantially identical”. Instead, Canadian legislators chose to use the term “identical”. Where “substantially” is used, it is generally considered to mean 90%. Thus Canadian legislators chose to remove this modifier of identical, with the result that the Canadian threshold is higher than the U.S. threshold. Perhaps the intent of removing the word “substantially” was to remove the uncertainty that this modifier caused. Since there is no numerical way to determine the extent to which two properties are alike, determining whether something is “substantially identical” requires a high level of judgment and may result in inconsistent results as objective standards may be difficult to determine. By contrast, determining whether two properties are identical is simple as any slight difference between the two properties causes them to no longer be identical. While this is administratively simple, it lays the rule open to manipulation as taxpayers may intentionally cause minor changes that leave them indifferent between properties, but cause the properties to no longer be identical such that they are excluded from the superficial loss rule. CRA administratively addresses the notion of identical property in an interpretation bulletin. In addition to commenting on several types of property, it notes that in general, properties are considered to be identical where a prospective purchaser would be indifferent between purchasing one property over the other. The determination is fact­based and requires that the essential qualities of each property be compared in order to determine whether they are identical. 31 This definition would seem to modify the legislation as it considers only the essential qualities of the properties. This is similar to the notion of “substantially identical”, or identical in all material aspects, and requires a more detailed analysis of the facts and circumstances of the transaction. This approach is not in­keeping with the wording of the legislation. In applying CRA’s general definition of a superficial loss to the example of Mr. Z, the share would appear not to be identical because a purchaser would not be indifferent between purchasing a share at the time that Mr. Z sold his first share, and the time that he purchased his second. This is supported by the fact that the value of the share at the time of sale was $80, but at the time of purchase was $85. While CRA may agree in this extreme case, it would almost certainly disagree where the changes in the business were more subtle as this would significantly curtail the application of the superficial loss rule. In such a case, it may fall to the Courts to establish the true nature of identical property. The Courts may rule that the legislation uses the high threshold of “identical” and this helps to ensure that only truly artificial transactions with absolutely no substance are caught. However, the Court may determine that the purpose, object, and spirit, is to deny superficial transactions such that where actions are deliberately taken to slightly modify properties to circumvent the rule, the General Anti­avoidance Rule (GAAR) may apply. The determination of identical property may be very fact specific. 31 IT­387R2, supra note 29, at paragraph 1.
Page 18 CRA’s definition incorporates more than the ordinary definition of the word “identical”, and in so doing, is interpreting and adding to the legislation. This is questionable territory as the Supreme Court has indicated that the Courts “cannot search for an overriding policy of the Act that is not based on a unified, textual, contextual and purposive interpretation of the specific provisions in issue” 32 If this is the case for the Courts, than this principle should apply even more so to CRA, which is simply an administrative body. More specifically, CRA appears to take the position that the intent of the legislation is to prevent the realization of losses arising from transactions between affiliated persons. This was essentially the position that it took in Landrus v. The Queen 33 , a GAAR case, where it argued that the superficial loss rule was one of several provisions that gives effect to the Act’s policy of denying recognition of a disposition unless there has been a true arm’s length disposition. The Tax Court applied the two­step process applicable to GAAR cases as outlined by the Supreme Court, and determined firstly the object, purpose, and spirit of the relevant provisions, and secondly, whether the transactions in the case frustrated this purpose. The Court found that there is no underlying policy in the Act to deny losses triggered in related­party situations. In fact, it found that the policy of the Act is to allow all losses, unless a specific exception is provided. The decision is under appeal. 34 While this commentary may be obiter, it suggests that unless the transfer fits within the wording of the superficial loss legislation, the loss may be claimed. Consequently, it may suggest that where the property is not “identical” according to the ordinary meaning of the word, the superficial loss rule does not apply. If this is the case, the superficial loss rule’s application would be severely curtailed indeed, for example as discussed above in the situation of Mr. Z. There has not yet been a case specifically on this issue, and so it remains to be seen how the Courts will interpret this provision, and under what circumstances transactions that effectively circumvent the superficial loss rule would be caught by GAAR. In addition to the lack of clarity regarding the notion of “identical property”, the wording of the legislation may contain a technical glitch. This may result in the denial of the entire loss where any property that is identical to the property sold is held at the end of the period. This is best illustrated by example. Assume Mr. X purchases 100 shares and the next day sells 80 of them, incurring a capital loss of $100. Based on the phrasing of the legislation, because he acquired identical property within 30 days of the sale, and still holds identical property (i.e. the remaining 20 shares) 30 days after the sale, his entire capital loss of $100 would be denied. Administratively, CRA has introduced a formula to address the situation 35 where a taxpayer holds some of the property at the end of the period. CRA’s formula determines the number of items that were actually sold, purchased within 30 days of the sale, and held at the end of the 32 Canada Trustco Mortgage Company v. Canada, 2005 SCC 54, at paragraph 41. 33 Landrus v. The Queen, 2008 DTC 3583 (TCC). 34 Laura J. Stoddard and Michael D. Templeton co­ed., Current Cases (2008) vol. 56, no. 4 Canadian Tax Journal 923­56, at 939­941. 35 CRA document no. 9203795, March 17, 1992.
Page 19 period. It then multiplies this by the loss per item, calculated as the amount of the loss on the sale divided by the total number of items sold. In Mr. X’s case the loss per item is $1.25 (i.e. $100/80), and the number of units that were purchased within the 30 day period, sold, and held at the end of the period is 20. Mr. X’s superficial loss is therefore $25. This formula is intuitively logical because Mr. X only owns 20 shares at the end of the period, but has sold 80. He has therefore “truly” disposed of 60 of the 80 shares. Any loss on these 60 shares is not superficial and should not be denied; the formula calculates this allowable portion. Similarly the formula recognizes that the loss is only denied to the extent that the securities were purchased within 30 days of the sale, and held at the end of that period. If Mr. X had instead purchased the securities last year, no loss would be denied because no securities were purchased within 30 days of the sale. CRA’s position appears to be in­keeping with the legislative intent in that it differentiates between the artificial and “real” portions of the loss. Arguably, the position merely patches a legislative glitch that would have denied more losses than was intended. On the other hand, the actual wording of the legislation denies more losses than CRA’s position, with the result that CRA has redefined the nature of an artificial loss and overridden the legislation. Because this is in taxpayers’ favour, it has not been challenged. However, as noted, CRA cannot add to the legislation; it is questionable whether CRA’s position would actually be upheld by the courts. It is interesting that in addition to the legislation not being amended, this technical interpretation does not seem to have been incorporated into an interpretation bulletin. It also does not appear to be mentioned in various tax software’s (ex. Taxprep and Profile) help notifications or warnings. Perhaps the general lack of attention to this rule is because, as discussed below, it is easily accidentally violated and possibly infrequently assessed by CRA. Furthermore, since the impact is generally only timing, taxpayers and legislators alike may not believe it to be worthy of further consideration. COMPLIANCE ISSUES CRA Audit In absence of data from CRA, it cannot be determined how often the superficial loss rule is actually assessed. From a CRA audit perspective, sufficient data is not provided in a tax return (regardless of whether paper or e­filed) to assess the rule. Tax returns request that the taxpayer provide, for each property disposed of, the name of the property, the date (or year) of acquisition, the proceeds of disposition, and the cost. This information allows CRA to see only that there has been a loss, not whether it is superficial. To assess superficiality, detail of the taxpayer’s holdings and the holdings of affiliated persons during the 30 days before and after the sale is required. It is interesting that Personal Taxprep software, unlike other software such as Profile, includes an additional box entitled “Loss deemed nil” in the capital gains reporting schedule. The taxpayer would check this box to reflect a denied loss such as a superficial loss. While this box may draw attention to the idea that not all losses are allowed, it does nothing to assist a CRA auditor in identifying a superficial loss where the taxpayer has not self­reported by checking the box.
Page 20 From a practical perspective, unless there are large losses, unusual losses, or other audit “red flags” requiring a review of this information, there is little audit incentive to request it. Such an exercise would require a thorough review of the holdings of both the taxpayer and affiliated person throughout the relevant period. Furthermore, it would be easy for a taxpayer to (either intentionally or accidentally) fail to provide detail for an affiliated entity, particularly where his holdings are large and he has multiple accounts. And if a superficial loss were identified, the result would generally only be deferral of the benefit of the capital loss until ultimate sale. Thus the benefit to the government would generally only be the time value of money. And unless the dollar amount were significant, this value would likely pale in comparison with the cost involved in identifying and enforcing the superficial loss rule. Consequently, unless the loss is large or becomes apparent in the course of an audit undertaken for other reasons, enforcement may be so costly that any benefit is outweighed. And if the loss is evident based on minimal investigation (ex. a purchase and resale), it is quite possible that the taxpayer was unaware of the law. If he was aware of the law he would either have taken legitimate steps to avoid its application as it is easy to circumvent. If he intended to violate the law, unless he decided to play the “audit lottery”, he would likely have taken at least some measures to make his violation less evident and so more difficult to audit. It may therefore be that many transactions caught are the result of non­tax­savvy taxpayers who do not have sufficient knowledge to legitimately circumvent the law, or unwary taxpayers who are trading for non­tax reasons. From a practical perspective, it would seem that only those who are unwary of the rule, and who were unlucky enough to be assessed, will be assessed. Preparer penalties Preparer penalties may apply where, for example, there is a false statement that arose due to culpable conduct of the advisor. Culpable conduct is defined in section 163.2 of the Act to include “an act or a failure to act, that (a) is tantamount to intentional conduct, (b) shows an indifference as to whether this Act is complied with, or (c) shows a willful, reckless or wanton disregard of the law.” Where the advisor relies on information provided by the client in good faith, penalties are generally not applicable. It is possible that claiming a superficial loss as an ordinary loss may result in the application of preparer penalties unless the preparer (for example) asked the client if any losses were superficial, and relied on the response in good faith. This would require an explanation of what a superficial loss is, and the client to have sufficient knowledge of his trading activity. If the client’s holdings are large and he relies on a broker to manage his affairs, a quick response that the loss is not superficial likely will not satisfy the good faith requirement. The adviser would know that the taxpayer had not actually confirmed whether any losses were superficial. It may be extremely difficult to prove any fault of the preparer such that the penalty may be difficult to assess. However, the possibility of the penalty being assessed exists, and raises the question of the extent to which audit responsibility that has traditionally been CRA’s has been forced onto tax practitioners. A detailed discussion of this issue is beyond the scope of this paper. However, practitioners may be well advised to document discussions with clients as to whether a loss is superficial prior to claiming it in a tax return.
Page 21 Possible resolution The main problem faced by CRA in its attempt to identify and deny superficial losses is a lack of information. Unless a taxpayer self­assesses, a superficial loss may be difficult to identify. One possible resolution is to require that stock brokers report all capital gains, capital losses, and securities held by taxpayers. This would provide CRA with the required information on a timely basis. However, in order to process and use this information, CRA would almost certainly require more sophisticated systems. These could be so prohibitively expensive that the benefit of identifying superficial losses would likely be outweighed. On the other hand, such a system may help to ensure compliance in other areas as well (such as reporting of capital gains) with the result that the combined benefit may outweigh the cost. An in­depth consideration of such a system, while beyond the scope of this paper, is perhaps a topic for future papers to consider. WHETHER THE POLICY INTENT IS APPROPRIATE AND IS ACHIEVED On the basis of the foregoing, the theoretical and practical need for a superficial loss rule has been demonstrated. The next issue to address is whether the superficial loss rule satisfies its legislative intent. In other words, it is necessary to determine whether the parameters set by the superficial loss rule appropriately identify artificial transactions and deny associated tax benefits. Legislative intent would appear to be an appropriate benchmark of the efficacy of the superficial loss rule, particularly as this same intent is expressed and addressed by several other countries including the US, UK, and Australia, as discussed later in this paper. As mentioned previously, Finland has no superficial loss rule, but because it operates in a different environment than Canada, it is not considered to be a reasonable benchmark for the Canadian taxation system. Superficial losses may be unintentional As previously noted, the superficial loss rule is designed to prevent artificial transactions from resulting in a tax benefit. The inherent assumption is that if a transaction falls within the rules, it was intended (by the taxpayer) to be artificial. If this were not so, there would be no apparent reason to deny the benefit as it would be a “real” transaction. The superficial loss rules may be unintentionally triggered under a variety of circumstances. By some they are in fact considered to simply be a “trap for the unwary” as opposed to a “true deterrent to recognizing accrued and unrealized capital losses”. 36 For example, the superficial loss rule may be unintentionally triggered in the following scenarios:
· Where an individual has different brokers who independently manage separate portfolios. The brokers (as opposed to the taxpayer who owns the portfolios) are responsible for making investment decisions. The brokers likely do not communicate with one another, and may not even know of each other’s existence. It is conceivable that a property may be sold at a loss in the one portfolio, but be purchased in the other. It may be administratively difficult to determine, for each loss realized, whether this has occurred. The application of the superficial loss rule in this circumstance would seem unfair as the 36 Grover, supra note 2 at 259.
Page 22 loss has truly and legitimately been recognized, and there has been no intentional tax planning or avoidance transaction. A similar scenario may occur where:
· Spouses maintain separate investment accounts and do not share information as to their stock purchases and disposals 37 ;
· An individual has a large investment portfolio and simply does not track (or remember) all of the securities purchased and sold; or
· Spouses intentionally keep their financial affairs separate due to a breakdown of the family relationship. In this case, the spouses are captured by the rules as they are still married and are living together, although due to the breakdown of their relationship each is, in substance, acting in his own self­interest. This may be made more pronounced where there is a pre­nuptial agreement which specifies that neither spouse is entitled to any assets belonging to the other spouse in the event of a marital breakdown. The imposition of the superficial loss rule in each of these situations would seem unfair as there has been no artificial transaction or intent to avoid taxation, the individual is clearly the appropriate unit of taxation, and the fact that an identical property was acquired around the same time that another was disposed of at a loss is purely coincidental. In fact, in the last example where spouses have a pre­nuptial agreement, the transfer of the denied loss from one spouse to other is inequitable and is contrary to both the legal form and economic substance of their relationship. Such examples illustrate that the superficial loss legislation can be heavy­handed as it captures both artificial and real transactions. Superficial losses and the RRSP Applying the superficial loss rules where an RRSP is involved may have unintended consequences. Assume Mr. X has a security with FMV of $80 and an ACB of $100. Mr. X sells the security and realizes a $20 loss. He then repurchases the security for $80 in his RRSP. In the absence of the superficial loss rule, Mr. X would have a $20 capital loss, and a security in his RRSP with an ACB of $80. However, as noted earlier, a taxpayer is affiliated with his RRSP. Consequently, the $20 loss would be denied, and added to the ACB of the remaining securities. Thus Mr. X could not claim his loss, and the ACB of the security within his RRSP would be increased from $80 to $100. Mr. X has effectively transferred his loss to his RRSP. Unfortunately, because gains are not taxed in an RRSP, this loss is of no use to Mr. X. The increased ACB will not in any way reduce the amount of tax he must pay on his RRSP (which is nil irrespective of his ACB), and will also not reduce the amount of tax payable by Mr. X upon withdrawal of funds. He has thus permanently lost the benefit of this $20 loss, a loss that he has economically and substantively suffered. This result was confirmed in an informal discussion with CRA’s rulings division, and there is no administrative position to rectify this permanent 37 See for example, J.M. MacGowan, “Tax Consequences of Marriage”, in Report of Proceedings of the Twenty­Sixth Tax Conference,1974 Conference Report (Toronto: Canadian Tax Foundation, 1974), 275­296, at 284.
Page 23 denial. 38 In addition, it would appear that the same permanent denial would apply to other savings vehicles such as the TFSA and RRIF. This denial is consistent with the subparagraph 40(2)(g)(iv) denial of any loss triggered upon transfer of a property to an individual’s RRSP. However, this subparagraph deals with direct transfers only. The legislative intent seems to be to deter deliberate transactions designed to use the RRSP as means to trigger losses using artificial transactions. While harsh (the loss is permanently denied), the rule prevents abuse of the RRSP which is already a tax­preferred vehicle. Arguably, indirect transfers such as a sale outside an RRSP and immediate repurchase by the RRSP should also be captured by this rule, and this is achieved by the superficial loss rule. However, as noted, the superficial loss rule may easily be inadvertently violated, and the violation may be the coincidental result of real transactions without tax motivation. For example, it is generally clear that an immediate sale outside an RRSP and repurchase within an RRSP should be caught by the rules. But, for example, where the repurchase occurs two weeks later, and the sale and repurchase are made by two different brokers, independently, and without knowledge of each other’s actions, it is difficult to see how denial of the loss on the initial sale achieves any policy intent whatsoever. In fact, the result is simply punitive. And this result is at odds with the legislative intent of the superficial loss rules which deny a loss until such time as the asset is truly disposed of. And it would also seem to be at odds with the legislative intent of subparagraph 40(2)(g)(iv) which is seemingly to deny losses deliberately triggered as a result of a transfer to an RRSP. This problem illustrates the difficulty in devising a threshold to identify those transactions that should be artificial. Where this threshold is set inappropriately, it may result at best in a deferral of a benefit, but in the case of an RRSP, a permanent denial. While both results are unfair, the permanent denial is extremely inequitable. Because a tax­savvy taxpayer with full knowledge of all holdings of affiliated persons could easily circumvent or avoid the application of the rule, this issue will likely only be encountered by the unwary. And since taxpayers empirically do not consider their RRSP holdings and transactions when preparing their tax returns, thinking that these are fully tax­sheltered transactions, very few indeed are likely to consider whether these securities could be impacted by the superficial loss rules. Furthermore, because the unwary will not recognize the issue, it will not be reported appropriately. Consequently, only those transactions that are caught by CRA will be treated as outlined by the legislation with the result that only those taxpayers that are both unwary and unlucky will actually be affected. Completeness of the superficial loss rule The superficial loss rules generally apply to spouses. However, a fair market value sale (assuming GAAR or other anti­avoidance provision is not applicable) to another individual is not denied. For example, where a security is sold to an adult child, any resulting capital loss may be claimed as it falls outside of the scope of the superficial loss rule. As a side note, this distinction is similar to that used for the attribution rules wherein income on fair market value transfers to 38 Author’s March 16, 2010 conversation with an officer of the Canada Revenue Agency’s Advance Tax Rulings Division.
Page 24 adult children are not attributed back to the transferor, whereas income on fair market value transfers to spouses are attributed back to the transferor. It would seem unfair that this is the case, particularly where the adult child lives with his/her parents and is still a part of the family unit. Similarly unfair is the fact that such a loss­triggering transaction with other extended family, friends, etc., is not denied by the legislation. The provision essentially penalizes those individuals who have not established sufficiently close social ties that they are able to engage in transactions that will trigger losses for tax purposes. Losses on such transactions, so long as they occur at fair market value and GAAR does not apply, would be allowable for taxation purposes. It appears that an individual is not affiliated with a partnership of which his/her spouse is the majority­interest partner 39 . Therefore, it may also be possible to structure a transaction (assuming that there was no application of GAAR or other anti­avoidance provision) to trigger what is in substance a superficial loss through creative tax planning. Means of Denying the Loss As noted, the legislation that denies the loss has defined parameters for loss denial. Two aspects of interest are the selection of 30 days as the cut­off point, and the notion of identical property. These raise the question of whether these two aspects of the definition achieve the legislative intent of the provision, including how easy it is for taxpayers to circumvent the rule. The technical aspects of the parameters, including the meaning of identical property, have been discussed. It was suggested that what constitutes identical property may be unclear and may result in a high threshold with few properties being considered identical. To the extent that this is the case, the legislation may not be particularly effective. As was suggested, the threshold of “identical” may be high. Consequently, the rule may be circumvented by slightly changing the nature of the property reacquired. For example, this might be achieved by rolling shares into a partnership and holding partnership units (which may be converted back into shares at a later date), or by holding units of a mutual fund corporation that holds only one share (instead of holding the share directly). Assuming that GAAR does not apply, this may be one way that a knowledgeable taxpayer could easily bypass the rule without penalty. Whether CRA and/or the Courts would agree with this interpretation is unclear. The appropriateness of the 30 day rule is now addressed. Discussion of the 30 Day Rule The selection of 30 days before and after a sale as the cut­off point for determining whether a loss is superficial in nature seems to have been made on the basis of the U.S. legislation (known 39 See the definition of affiliation in section 251.1 of the Act. Affiliated parties include a person and a partnership with whom he/she is a majority partner, but do not make mention of a spouse of such a person.
Page 25 as “wash sale rules”) which utilizes the 30 day rule. This selection appears to have been made without undertaking any Canadian studies or research. 40 Since the 30 day rule plays such an important role in determining whether a transaction falls within the scope of the superficial loss rule, one would expect that this time period be selected on the basis of reason or logic. In reality, US legislators seem to have selected this time period in an arbitrary fashion, based on a relatively brief discussion in the Senate of the period of time that should be considered. Options proposed included “at or about”, 30 days, and 60 days. There does not appear to have been any real debate or research as to the legitimacy of any of these options. Several senators expressed their views, a vote was taken, and 30 days was passed into law. This 30 day time period has not been modified since the rule was first passed into law in 1921. 41 This begs the question of whether 30 days is still appropriate almost 90 years later in the context of the current economy, particularly in terms of market volatility. This is perhaps best illustrated with an example. Let us assume that there is no market volatility over a given time period. Mr. X sells a security with an accrued loss for its current fair market value of $100. He knows that there is little or no market volatility over the next month, so that he can almost certainly repurchase the same security after 30 days for $100. He is not captured by the superficial loss rule, but has not changed his economic position as he knows that he will repurchase the security at the same cost a month later. In this case, let us call it scenario A, the 30 day rule is a poor measure to delineate an artificial transaction; the appropriate period is longer. By contrast, assume that there is tremendous market volatility. Mr. X sells a security with an accrued loss for its current fair market value of $100. He knows that the market is highly volatile, so that the value of the security may change dramatically the second he sells it. In this case, let us call it scenario B, the 30 days rule is also a poor measure to delineate an artificial transaction; the appropriate period is shorter. Thus in order to evaluate the efficacy of the 30 day rule, we must consider a measure of market volatility. The more volatile the market, the shorter the time period necessary to ensure that there has been a substantial change in economic substance so as to ensure that the transaction is not artificial. It is interesting that volatility does not appear to have been considered by Congress at all in 1921 and arguably, even if it had been considered, this volatility would likely differ from the volatility of present day markets. One measure of volatility is the Chicago Board Options Exchange (CBOE) Volatility Index, or VIX. This index specifically tracks the S&P 500 index, and attempts to predict how volatile it will be over the next 30 days. 42 There are other similar indices for other groups of securities; the VIX is used as an example. The VIX is important for option pricing, but it is also important in terms of the superficial loss rule. If this index indicates that there is little volatility over the next 30 days, we are in the arena 40 Grover, supra note 2. 41 Michael Fuerch, “The Wash Sale Rule: Deserving of a Second Look,” Special Report, Tax Notes, December 15, 2009, at 1192. 42 Ari J. Officer, “The Volatility Index Is Falling: A Bullish Sign?”, Time, April 22, 2009.
Page 26 of scenario A above, and 30 days may be too short a period. By contrast, if the index indicates that there is tremendous volatility, we are in the arena of scenario B and 30 days may be too long a period. Figure 1 charts the VIX from January 1990 to December 2009. As can be seen, although the VIX has historically averaged at approximately 20, there have been times of greater and lesser volatility. Notably, the VIX moved from a period of relative stability to approximately 30 in 2007, and reached a high of 80 in late 2008. In April of 2009, it declined to 40. 43 While a detailed discussion of volatility indices is beyond the scope of this paper, the change in this index illustrates that volatility changes over time, sometimes dramatically so. Therefore, during certain economic periods (such as in 1995) there may be relatively low volatility, while in others (such as in 2008) there may be very high volatility. Consequently, selecting an arbitrary 30 day period will be overly lenient in periods of relative stability, and overly punitive in periods of economic turmoil. ______________________________________________________________________________ Figure 1: CBOE Volatility Index from 1990 to 2009 ______________________________________________________________________________ On the one hand, the 30 day rule clearly delineates superficial transactions and so has the advantage of simplicity. As long as markets are relatively stable such that 30 days may be approximately correct, the rule may represent a reasonable compromise between equity and simplicity. However, in times of fluctuation or extreme stability the appropriateness of the 30 day rule is highly questionable, and likely does not represent a reasonable trade­off between equity and simplicity. In fact, the rule may be undesirable from a policy perspective because it is in periods of economic turmoil that taxpayers may require additional government assistance such as in the form of tax breaks. Also, because this rule ignores the economic reality of the market, it may unfairly deny losses where securities are sold and then repurchased due to a change in investor outlook with regard to the stock. 43 Ibid.
Page 27 The selection of the 30 day period may have real economic consequences. For example, it may cause an investor to hold securities that have dropped in value immediately after purchase for at least 30 days, where in absence of the rule he would have preferred to sell some of the securities at a loss and reinvest the proceeds in a more efficient investment. Similarly, it may encourage an investor who has sold a security in order to trigger a capital loss to delay his repurchase of the stock for 30 days. While a remote possibility, this could theoretically destabilize markets to the extent that investors withhold capital for 30 day periods on a large scale. As noted above, there is no Canadian data available to determine whether, and to what extent, taxpayers wait 30 days to repurchase stock. Empirically, it would seem that this is the case, though presumably this is tempered by market expectations. For example, if an investor believes that repurchase will result in a greater profit to him than the benefit of immediate utilization of a capital loss, he will presumably repurchase the stock. This assumes that the investor is aware of the superficial loss rule and is exercising care to ensure that he does not violate it. It is interesting that the 30 day period is important in both Canada and the US, but is irrelevant in countries such as the UK and Australia. These countries’ legislation is discussed in more detail in the international experience section below. In countries such as the UK and Australia, the parties to the transaction are important, together with whether the transaction is an avoidance transaction. The time period is relevant, but is not mandated to be 30 days. This inherently recognizes that 30 days may not be the appropriate time period for all types of property during all economic periods. For example, as will be discussed, the Australian rules do not deny the capital loss where the sale and repurchase is market driven, irrespective of the time period between sale and repurchase. It is also interesting to compare the issue of volatility with respect to recognition of superficial losses with other tax provisions that are impacted by volatility. For example, the maximum permissible surplus in a registered pension plan used to be 10% until recent amendments were proposed to increase this limit to 25% 44 . In times of economic stability, it would appear that a 10% threshold is reasonable, and would provide a cushion in the event of market decline. However, in times of economic turmoil where markets can fluctuate by 10% in a single day, such a cushion is insufficient. This was realized during the recent economic crisis, and for this reason amendments were proposed. In other words, a change in market volatility necessitated changes in legislation. As with this issue it seems that the underlying assumption as to market volatility with respect to the 30 day rule is no longer appropriate, and should perhaps be amended to reflect the current economic reality. The question then becomes one of what the appropriate period should be. The foregoing discussion illustrates that this is dependant, in part, on the economic climate. It is also dependent on the nature of the particular security as volatilities will vary across industries, security types, and even by company. Thus, whatever period is chosen will necessarily be overly lenient for certain types of property during certain periods, and overly punitive for others. Fairness would therefore dictate that there be no specified period (as in the Australian and UK frameworks) and that each transaction be 44 Canada Revenue Agency, “Registered pension plans (RPPs) frequently asked questions” (online: http://www.cra­arc.gc.ca/tx/rgstrd/rpp­rpa/fq­eng.html#q28).
Page 28 examined on the facts of the situation. And this illustrates the trade­off between ease of administration of defining a threshold, and the more costly and complex (though possibly more equitable) approach of identifying artificial transactions on a case­by­case basis. An intermediate solution may be to modify the 30 day period on an annual basis by regulation, to account for market volatility. However, this would still be necessarily inappropriate (either overly punitive or overly lenient) for certain property, and would add additional complexity to the taxation system. It would therefore appear that an “either/or” approach may be appropriate; either a fixed threshold should be selected such as 30 days, or each scenario should be analyzed on the basis of the facts. It is suggested that legislators revisit this trade­off. If it is determined that an arbitrary threshold is still the best compromise for Canada in the interests of ease of administration, the legitimacy of the 30 day threshold should be re­examined to ensure that it is, with regard to the current environment still the best compromise. INTERNATIONAL EXPERIENCE Many countries have legislation that, similar to the Canadian superficial loss rule, seeks to deny capital losses on artificial transactions. Although the legislative intent is the same, each country achieves this intent in a different manner. It is helpful to understand the manner in which other countries address this issue as international experience puts the Canadian rules into a context for the purposes of benchmarking, and may also suggest alternative methods of implementing the legislative intent. United States The U.S. has a rule very similar to the Canadian rule; this is the case because Canada’s rule was in fact based on the U.S. legislation. The U.S. rule mandates that where a taxpayer sells a stock and claims a loss, that loss will be denied where the taxpayer purchased the same or substantially identical stock or security (including an option or contract to purchase) 30 days before or after the disposition. 45 The U.S. rule is narrower in that it only applies to stock and securities, and associated options or contracts to acquire them. By contrast, the Canadian rule applies to a broader range of property and so includes such items as commodity futures. The U.S. rule applies to “substantially identical” property whereas the Canadian rule applies only to “identical” property. It would thus appear that the U.S. rule is broader in this respect as substituted property does not have to be absolutely the same. The determination of what constitutes “substituted property” must be made on a case­by­case basis 46 . Also unlike the Canadian rule, the U.S. has no requirement that the property be held at the end of the 30 day period. There is also no mention of affiliated persons in the U.S. rule, possibly because in the U.S. there is family unit taxation such that this aspect of the rule is unnecessary. 45 Fuerch, supra note 41. 46 Ibid, at 1194.
Page 29 UK The UK employs the concept of “connected persons” to determine whether (and to what extent) a capital loss may be realized. A connected person is defined to include, for example, one’s spouse, children, grandchildren, and a controlled company. A capital loss triggered upon the transfer of a property to a connected person may only be realized to the extent of capital gains realized as a result of transfers to the same connected person. However, where the connected person is one’s spouse the capital loss is denied, but may generally be realized by the spouse upon disposition of the asset to another party. 47 This rule is similar to the Canadian superficial loss rule in that it denies the capital loss on a property realized upon transfer to one’s spouse. It differs in that sales to people other than those that are affiliated with the taxpayer (such as adult children) fall within its scope. It also differs in that there is no “30 day period” component to the rule, and there is no specific provision to address indirect sales. For example, under these U.K. provisions alone, there would appear to be nothing to prevent one spouse from selling a share with an accrued capital loss on the open market to realize his loss, and the other spouse immediately purchasing this share on the open market. This transaction would effectively trigger the loss while allowing the spousal unit to continue to hold the stock. Such a transaction, however, would appear to be caught by an anti­avoidance rule 48 . This is because an anti­avoidance rule captures a transaction that is undertaken to circumvent tax rules, but achieves the same result as the transaction contemplated by the rule 49 . In this example, the purchase and sale on the open market was undertaken to circumvent the loss denial that would have occurred if the sale had been made directly to the spouse; the loss would therefore be denied. The provision regarding connected persons is interesting as it recognizes that there may be a special relationship between certain persons in addition to a spouse, such that transactions between them may be artificial. It consequently prevents a taxpayer from “cherry­picking” by artificially recognizing only losses. It appears that it is relatively easy to circumvent this rule, and it is not clear to what extent an anti­avoidance rule would apply. For example, one could sell gain and loss securities to a connected person. The loss could be utilized to shelter the gain, provided that a general anti­ avoidance provision did not apply. The connected person could then sell the “gain security” on the open market, but retain the “loss security”. The “loss security” is thus still retained within the connected group. Similarly, in a Canadian context, this loss would be allowed so long as it was 47 HM Revenue and Customs, “How to work out if you've made a loss” (online: http://www.hmrc.gov.uk/cgt/intro/losses.htm#1). 48 An in­depth discussion of the application of the anti­avoidance rules is beyond the scope of this paper. Application of the rule is determined based on a superficial analysis of the intent of the rule and theoretical application. This may not be upheld by case law. 49 HM Revenue and Customs, “Guidance from Anti­Avoidance Group” (online: http://www.hmrc.gov.uk/avoidance/aag­risk­assessing.htm).
Page 30 to a non­affiliated person. The need to “package” the sale with a gain and loss security would not be necessary to utilize the loss in Canada. The connected person provision is quite inflexible and may cause unintended results. The proviso that the loss may only be recognized as an off­set to gains realized on transactions to the same connected person seems harsh and may result in genuine losses being denied. For example, if a parent wishes to sell his business (his only asset) to his child, but the business has an accrued loss, the loss is denied as he has no other assets to sell with accrued gains. Presumably planning could be undertaken to address this. As in Canada, the threshold for determining those transactions that should be considered artificial is set without regard to the particular facts of the situation, and this threshold, as discussed above, differs from the Canadian threshold. This initial threshold will necessarily unintentionally capture certain “real” transactions and exclude (i.e. allow) certain “artificial” transactions. Based on the specific provisions alone, the class of people affected (connected persons) is larger in the UK than in Canada (affiliated persons). However, the UK rules do not address indirect transfers such as the one contemplated above. Such transactions could fall within the scope of a general anti­avoidance rule, depending on how the rule is applied. Consequently, the base rule coupled with the general anti­avoidance would seem to cast a broader net than the Canadian rule. The Canadian “30 day rule” is effectively replaced by a general anti­avoidance rule such that, from this perspective, (hopefully) fewer “real” transactions would be captured as the rule considers facts and circumstances. Australia Australia does not appear to have a superficial loss rule equivalent. However, “wash sales” are still a concern and are addressed by a rule similar to the Canadian GAAR. The Australian Taxation Office issued a taxation ruling regarding wash sales to demonstrate instances of the application of the avoidance rule to wash sales. 50 The taxation ruling indicates that the anti­avoidance rule may be applicable where the main purpose of the transaction is to derive a tax benefit, and also provides specific examples. It notes that the determination of applicability is dependent upon an analysis of the particular facts of the situation. Examples of situations where the anti­avoidance provision would be applicable include where, within a short period of time, the taxpayer re­acquires the same (or substantially similar) asset. 51 There is no definition of “short”; this may create uncertainty for taxpayers, but also seems to recognize that what constitutes a “short” period of time may differ depending on the circumstances. Specific examples provided include the case of an individual who sells his shares at a loss, and then re­purchases the same shares three days later due to new information with regard to the 50 Taxation Ruling TR 2008/1, “Income tax: Application of Part IVA of the Income Tax Assessment Act 1936 to ‘wash sale’ arrangements”, January 16, 2008. 51 Ibid, at paragraph 4.
Page 31 company. In this case, the anti­avoidance rule would not apply as there is a non­tax reason for the repurchase. In absence of taxation rules, the same transaction would have occurred. 52 Such a sale and repurchase would have been captured by the Canadian superficial loss rule. In contrasting the Australian rules with the Canadian superficial loss rule, it can be seen that both have the intent to disallow artificial loss transactions that generate a tax benefit, though each approaches the concern in a different manner. The Canadian rules create an arbitrary cut­off point to determine whether a transaction is superficial, with the result that the rule may capture both artificial and “real” transactions; it may similarly exclude certain artificial transactions that have been structured so as to circumvent the rules. Thus although the Canadian rule is fairly straight­forward in its application and therefore theoretically relatively easy to administer, it is not particularly well­targeted to achieve its policy intent. By contrast, the Australian rules seek to analyze each transaction for the purpose of determining whether the loss should be considered artificial. Thus the Australian rule better accomplishes the legislative intent by more accurately targeting those transactions that are offensive. On the other hand, the Australian rule may be more difficult to apply as it requires a thorough examination of each transaction which may be administratively difficult. Furthermore, since it seems to consider intention (ex. was the repurchase due to new information or was it pre­planned), it may be easy for taxpayers to window­dress transactions so that they are not considered to be artificial. Clearly, both taxation systems identify artificial transactions as a policy issue. The Canadian system resolves this issue by creating a seemingly arbitrary threshold for determining those transactions that are offensive. By contrast, the Australian system takes the opposing approach that requires an analysis of each particular transaction to determine whether it is in fact offensive. Each country has chosen a policy to strike a balance between ease of administration and better targeting of artificial transactions. Finland In Finland there are no "wash sale rules", and although there is an anti­avoidance provision that may deny transactions that are tax­motivated, this rule has never been applied to wash sales. 53 Conclusions that can be drawn from the international experience On the basis of this discussion, with the exception of Finland, each of these countries is clearly concerned that capital losses may be triggered by means of artificial transactions. Consequently, each seeks to address this concern through its legislation, though each does so in a different manner. As noted, because the environment in Finland is quite different than that in Canada, the Finnish approach of not denying any artificial transactions is less helpful in terms of benchmarking. In analyzing the various examples of countries’ attempts to address artificial transactions, there appears to be a spectrum of approaches. One may conceptualize a theoretical spectrum, as illustrated in Figure 2, that demonstrates that countries must create legislation that compromises 52 Ibid, example 6 at paragraph 61. 53 Grinblatt and Keloharju, supra note 18.
Page 32 between objectivity of definition, certainty, simplicity, and less accuracy in identifying artificial transactions at the one end, versus increased use of judgment, less certainty, greater complexity, and possibly greater equity at the other. ______________________________________________________________________________ Figure 2: Spectrum of approaches to identifying artificial transactions vApplication is highly objective vCertainty vEase of administration vEase of taxpayer compliance vLess accuracy in identifying artificial transactions vApplication requires more judgment vPossibly less certainty (more grayness) vMore difficult to administer vPossibly more difficult to comply with due to lack of certainty v Possibly greater equity vCombination such as a highly objective threshold combined with a GAAR­type rule.
______________________________________________________________________________ At the extreme right end of the spectrum are countries (such as Australia) that do not have a specific superficial loss rule, and instead address artificial capital losses via a general anti­ avoidance rule. This provision considers all of the facts of the transaction and so would theoretically not capture “real” transactions. However, such a rule may be difficult and costly to implement, and may create uncertainty for taxpayers as to what is considered to be an artificial transaction. It may also be easy for taxpayers to circumvent the rule by “window­dressing” a transaction to make it appear “real”. Some countries (such as the UK) occupy the middle of the spectrum, as they adopt an intermediate approach of defining a basic threshold, and then capturing offensive artificial transactions that are within the intent (though not technical definition) of this threshold through the use of an anti­avoidance provision. Such an approach attempts to strike a balance between the ease of administration of defining a threshold, and the more costly and complex (though possibly more equitable) approach of identifying artificial transactions on a case­by­case basis. At the extreme left end of the spectrum are countries (such as the U.S. and Canada) who define those transactions that are artificial. This threshold objectively defines artificial transactions without requiring a thorough analysis of the facts of the transaction, and in doing so may both inadvertently capture transactions that should not be considered artificial from a policy perspective, and exclude those that should be considered artificial. It (again theoretically) clearly establishes those transactions that are artificial for the purposes of the legislation. Thus in the trade­off between accuracy of identifying artificial transactions, and ease of administration Page 33 together with certainty of defining artificial transactions, the U.S. and Canada have apparently opted for ease of administration and supposed certainty of definition. However, as discussed, issues have been identified with certain definitions, such as what constitutes “identical” in Canada. This grayness questions how clear the threshold truly is. If the threshold truly means “identical” very few properties are captured and the rule is toothless as it is very easy to circumvent. If, on the other hand, the threshold is as CRA interprets it, there is a need to examine the particular facts to determine if the property is identical. This analysis is seemingly contrary to the intention to devise a clear, objective, and easy to administer threshold. The analysis, though narrower as it is only with regard to the type of property as opposed to the entire transaction, is somewhat similar to the nature of the analysis required in the UK and Australia. In other words, perhaps in Canada one must undertake an analysis of the facts to determine if property is identical; if it is not, there is substance to the transaction and so there is no reason to deny any resulting loss. If this detailed factual analysis must be undertaken, then the Canadian approach would seem to objectively legislate only certain aspects (ex. the 30 day threshold). This combined approach appears to be arbitrary as once a fact­specific analysis must be undertaken, it would seem more consistent to require a fact­specific analysis for the entire definition. To the extent that an analysis is required, the rule may be difficult and costly to administer and comply with. Thus it seems that in spite of the theoretical trade­off outlined, the Canadian legislation may manage to be costly, complex, and inequitable. While the theoretical spectrum underlines the difficulty in identifying artificial transactions and the existence of tradeoffs that must be made by legislators, it assumes that it is possible to objectively define a threshold that will generally identify artificial transactions. However, due to the complexity of the economic environment, this may not actually be the case. In other words, it may be difficult if not impossible to set highly objective criteria to determine whether a transaction should be considered to be artificial. The Canadian rule demonstrates that where this clarity is not achieved, the intended sacrifice of some equity in the interest of simplicity is not rewarded, and the result is instead an unfortunate combination of complexity, inequity, costliness, and uncertainty. CONCLUSION AND SUGGESTIONS FOR REVISION As has been illustrated, in the absence of a superficial loss rule, taxpayers would engage in artificial transactions to realize and claim capital losses, and this could negatively impact tax revenues. Consequently, a superficial loss rule is necessary to prevent this activity. In its current form, the superficial loss rule is ineffective as it is both very easy for a knowledgeable taxpayer to circumvent, and very easy for an unwary taxpayer to inadvertently violate. The definition relies heavily on a 30 day threshold and the notion of identical property. The 30 day threshold appears to have been arbitrarily selected, ignores the reality of the taxpayer’s particular situation, and ignores the general environment including market volatility. The notion of identical property is legislatively undefined, and a strict interpretation may lead to a very narrow class of property being captured by the rule. As was noted, a legislative anomaly has existed within the legislation since its introduction, and has been administratively (though not legislatively) addressed. Furthermore, where RRSPs are
Page 34 involved, the legislation is drafted in such a way that accrued losses may be permanently denied with the curious consequence that real transactions without tax motivation may lead to the permanent denial of a loss truly suffered. In other words, the legislated threshold poorly identifies those transactions that should be considered artificial. As a result of this, it may be administratively difficult for taxpayers to identify and report superficial losses. It may also be costly for CRA to identify superficial losses upon audit, with the result that the cost­benefit ratio of such an audit makes it less profitable (and less likely to be pursued) than other available audit areas. Consequently, it appears that legislators, taxpayers, and CRA alike may all pay very little attention to the superficial loss rule. While this means that unwary and unlucky taxpayers may be unfairly caught, it may also mean that aggressive taxpayers can realize superficial losses either by easily circumventing the rules, or simply by failing to report superficial losses. It is suggested that legislators revisit the continuing legitimacy of the 30­day period in the context of the current economic environment. Similarly, the notion of “identical property” should be revisited as “identical” may be too high a threshold, and may fail to capture transactions that should be considered artificial. Consideration may also be given to introducing a rule to ensure that instead of requiring that superficial losses be added to the ACB of securities within an RRSP, that the loss instead be suspended outside of the RRSP until the security is actually disposed of within the RRSP. Due to the number of issues identified with the current structure of the rule, it is suggested that legislators consider whether the superficial loss rule should be replaced with a threshold that considers all the facts of the transaction to determine whether it is artificial. This “softer” threshold is consistent with the treatment accorded in countries such as the UK and Australia. As has been demonstrated, the current rules may be easy to inadvertently violate, easy to circumvent, costly to audit, and inequitable in a variety of circumstances. A more purpose­ oriented threshold may be equally costly to audit, but should better target offensive transactions. Such a change would hopefully cause the superficial loss rule to no longer be a trap for those who are unknowledgeable, unwary, and unlucky
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