Oct 10, 2024
INTRODUCTION: LOSS CARRYOVER CLAIMS EXCEEDING $200,000, ARE MORE LIKELY TO GET AUDITED
A routine loss carryover claim could trigger a tax audit. This is especially so, where the taxpayer is not aware of the relevant considerations of the CRA with respect to such claims. It is even more difficult where these policies of the CRA are only internal.
This article discusses loss carryovers and tax audits, while disclosing an important internal policy of the CRA to audit loss carryover claims exceeding $200,000.
As we reveal the CRA Internal policy on Loss carryover, we will discuss some of the kinds of loss carryovers claims available to Canadian taxpayers; when a taxpayer is entitled to make such claims; when an audit could arise and how to handle tax audits. We will also offer some pro-tax tips, in order to guide taxpayers in their dealings with the CRA.
CRA INTERNAL POLICY ON LOSS CARRYOVERS
As our experienced Canadian tax lawyers have earlier disclosed in a previous post, in R V Posteraro 2014 BCPC 31: during a voir dire on the admissibility of evidence, a CRA official revealed that the CRA refers all loss carryover claims in excess of $200,000 for audit consideration. In that case, the taxpayer claimed $750,000 in non-capital loss carryover, and this triggered additional tax audits scrutiny that eventually led to tax reassessments. His claim, in addition to his previous history with the CRA, culminated in criminal charges for tax evasion.
WHAT ARE LOSS CARRYOVERS?
Loss carryovers refer to the ability of taxpayers to carry their incurred losses over to future or previous years, from the year the losses were generated. A taxpayer does this in order to offset taxable income in those future or previous years. Various kinds of losses can be carried over. This includes non-capital losses, capital losses and business investment losses.
Non-Capital losses
These losses originate from non-capital sources, i.e. business expenses, disposition of non-capital properties, etc. For a tax year, non-capital losses are generated when a taxpayer’s expenses exceed income in that year. Non-capital losses are deductible against any source of income, including capital gains. They are fully deductible in the year they were generated.
Sometimes, non-capital losses cannot be fully deducted in their year of generation. In that case, they can be carried over to offset taxable income for any of the previous 3 tax years or the succeeding 20 tax years, from the year the loss was generated.
Capital Losses
These losses are generated when capital properties are disposed for an amount that is less than the cost of the property to the taxpayer. A Capital Property is a property held to generate capital gain or loss, upon its disposition; as opposed to an Inventory Property, which is a commodity of the business, and held to generate business income from a resale. In order to ascertain whether a property constitutes capital property, the court looks at the entire circumstances of the case. The factors the court considers in making such determination include: the nature of the property disposed, the circumstances surrounding their disposition, the frequency of disposition of such properties, the length of time the property was owned.
Generally, capital losses can only be used to offset capital gains income. However, only 50% of such losses are allowable to do so. This means that only ½ (half) portion of the capital loss is allowed to offset a half portion of the capital gains income (Taxable Capital Gain). Where allowable capital loss exceeds taxable capital gains for the year, a Net Capital Loss results. The net capital loss can be carried over to offset capital gains income in any of the 3 tax years prior to the year they were generated or in any of the succeeding tax years indefinitely.
Allowable Business Investment Losses (ABIL)
These are capital losses that generally accrue from an arm’s length disposition of debt or shares of a qualifying Canadian Controlled Private Corporation (CCPC). That is, a small business corporation earning active business income in Canada (with all or substantially all of its assets dedicated to earning such income). See Section 39 (1) (c) of the ITA. 50% of such losses are allowable to offset income from any source. This allowable portion is the ABIL.
Where the ABIL is not fully deductible in the tax year that they were generated, they can be carried over to offset income in any of the 3 tax years preceding the tax year they were generated. They can also be carried forward to offset incomes generated in any of the future ten tax years, succeeding the tax year in which the loss was generated. Where the losses cannot be fully deducted after 10 tax years, they become transformed (reverted) into a net capital loss, which can then only offset capital gain income.
AUDITS OF A LOSS CARRYOVER CLAIM: WHEN AND WHAT TO EXPECT
A taxpayer’s filings may still be audited, even where the taxpayer’s loss carryover claim, is well below the $200,000 CRA internal threshold as earlier disclosed. This is because the CRA has other criteria for selecting tax filings for audit. These criteria include random selection, third-party tips, past history of non-compliance and returns comparisons with third party information. Although the $200,000 CRA internal threshold significantly increases the odds for an audit, it does not preclude a CRA tax audit for loss carryover claims in lesser sums.
An audit is an examination of the returns and supporting accounting records of a taxpayer, by a CRA tax auditor. This is done to determine if the taxpayer’s income and expenses were properly reported. Audits are also done to ensure taxpayer’s compliance with relevant tax legislation including information reporting requirements such as T1135 reporting of foreign assets.
The CRA has broad information-gathering powers during audits. These powers apply to both the taxpayer and to third parties. However the CRA does not have the power to compel a taxpayer to answer questions during the audit stage, except such questions relate to information that ought to be in the books and records of the taxpayer. See Ghermezian V Canada 2023 FCA 183 para 20-25. Regardless of the foregoing, the failure of a taxpayer to answer CRA questions could result in adverse assumptions by the Tax Auditor, leading to additional tax liabilities for the taxpayer. It is therefore important for the taxpayer to pick their battles carefully after careful discussion with a top Canadian tax lawyer.
The CRA usually sends a notice, when a taxpayer’s returns are selected for an audit. Our experienced Canadian tax lawyers are always available to counsel and represent you during tax audits. We can advise you on your rights and present your case in the best and most effective manner. We can also guide you on when and how it will be beneficial to answer CRA questions. Having a Canadian tax lawyer from the inception of your audit is frequently vital.
HOW TO CHALLENGE THE OUTCOME OF A CRA AUDIT
A taxpayer, who does not like the outcome of an audit, usually has 90 days to object. Section 156 of the ITA empowers taxpayers to file notices of objection for tax assessments and reassessments. A Notice of Objection commences the CRA dispute resolution process. A CRA Appeals Officer will be assigned to deal with the objection.
A taxpayer who fails to object within the 90-day period, can seek an extension within a one year period from the assessment or reassessment sought to be challenged. To obtain this extension, the taxpayer must show, among other things, a bona fide intention to object within the 90-day time period.
Where a taxpayer is still not satisfied with the decision of the CRA Appeals Officer, the taxpayer can appeal to the Tax Court of Canada (TCC). It is important to note that, a taxpayer cannot appeal directly to the TCC without first initiating the internal objections process of the CRA.
PRO TAX TIPS: SOME EXPECTED CHANGES TO THE LOSS AND CARRYOVER REGIMES
The last federal budget proposed changes to increase the deductible portion of capital losses from ½ to 2/3. This will result from a corresponding increase in the taxable portion of capital gains. The amendment is intended to take effect from June 25, 2024. As part of the amendments, net capital losses sought to be carried over to another tax year, will only be deductible at the same inclusion rate applicable to taxable capital gains in that year.
Furthermore, the deductible portion of ABILs is sought to be increased from ½ to 2/3. This is also proposed to take effect from June 25, 2024. However, unlike Capital losses, the ABIL rate will not be adjusted to mirror inclusion rates that were applicable in the tax years they were carried-over to. The 2/3 ABIL rate will apply to any income sought to be offset, in any applicable tax year, provided the loss was generated after June 24, 2024.
Our experienced Canadian tax lawyers are available to help you plan your tax affairs, in order to mitigate unexpected outcomes.
Frequently Asked Questions (FAQ)
In addition to an ABIL, in what other circumstance can capital losses be used to offset other income that is not capital gains?
When a taxpayer dies, the net capital losses of the deceased taxpayer can be used to offset any source of income in the taxpayer’s year of death, the immediate preceding year, or in both years.
What is the difference between an allowable capital loss and a net capital loss?
An Allowable Capital Loss is that portion of the capital loss amount, that is permitted to deduct capital gains income. Allowable Capital Loss is 50% of the capital loss, and it is permitted to deduct taxable capital gains (which is 50% of capital gains amount). However, there are expected changes from the 2024 Federal Government budget, to respectively increase the deductible and taxable portions of capital losses and gains to 66.67% (2/3).
On the other hand, a net capital loss is the loss that results when allowable capital losses exceed taxable capital gains for the tax year.
Can a Loss, cause my net income to be in the negative?
The answer is No. Your net income (capital, non-capital or otherwise) cannot be in the negative. When the relevant taxpayer losses exceed applicable income, the resulting net income will be zero, instead of a negative value. The excess losses of the taxpayer can then be carried over to future or previous years, where applicable.
Disclaimer: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
