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Taxing the “Daytrader”
With rising stock markets and direct access to the markets through online discount brokers, more and more individuals are managing their own stock portfolios. Some individuals are even active daily, to the point where they only hold a particular stock for a very short period, to benefit from the current movement in the stock price. These individuals, who trade in their portfolio on a daily basis, have become known as “daytraders.” The purpose of this article is to review the tax issues that daytraders face when they report their gains and losses on their income tax returns.
Gains―are they income or capital gains?
For most individuals, any gain they realize when they dispose of a share investment is a capital gain, only a portion of which is taxable. The inclusion rate for capital gains decreased from 3/4ths to 2/3rds for dispositions after February 28, 2000, and to 1/2 for dispositions after October 17, 2000. Generally, capital losses can only be used to reduce capital gains and are deductible at the same inclusion rate that applies to the capital gain.
However, when the level of a person’s stock trading reaches a certain point, the Canada Customs and Revenue Agency (CCRA) may take the view that the gains and losses realized on stock transactions are income gains and losses. In other words, they would argue that the level of trading activity constitutes a business for the individual. This is a particular risk for daytraders.
In determining whether gains and losses are income or capital in nature, a number of factors have to be considered. These include:
Frequency of transactions. If you have a history of extensive buying and selling of securities or a quick turnover of property.
Period of ownership. If you hold securities for a short period of time.
You have some knowledge of or experience in the securities markets.
Securities transactions form part of your ordinary business.
You spend a substantial amount of your time studying the securities markets and investigating potential purchases.
Security purchases are financed primarily on margin or by some other form of debt.
You have advertised or made it known that you are willing to purchase securities.
In the case of shares, the shares are speculative or have low dividend yields.
No one factor will be determinative. However, where a combination of the above factors apply to your situation, the CCRA may consider you to be carrying on a business, so gains will be treated as business income and will be fully taxed. It is important to be aware of these factors, to understand how your gains or losses may be taxed by the CCRA.
Canadian securities―capital gains and losses
The Federal government allows investors to make an election to tax gains and losses from Canadian securities as capital gains and losses. If you qualify for this election, it can add certainty to characterizing gains and losses as capital in nature. You will qualify to make this election if you invest in Canadian securities and if you are not a “trader or dealer in securities,” or a non-resident. You will be considered a “trader or dealer in securities” if you participate in the promotion or underwriting of an issue of shares, bonds or other securities or you hold yourself out to the public as a dealer in these securities. As well, if you utilize special knowledge of a corporation not available to the public to realize a quick gain, you will be considered a “trader or dealer in securities” for those particular securities.
For the purpose of making this election, Canadian securities include shares of the capital stock of a corporation that is resident in Canada, a unit of a mutual fund trust or a bond, debenture, bill, note, mortgage or similar obligation issued by a person resident in Canada. Options, commodities and commodity futures do not qualify however.
In addition, it is important to note that foreign securities do not qualify for this election?it is common for most investors these days to trade in stocks of companies that are not resident in Canada. For these securities, this election provides no protection. As well, there are certain securities that you should be aware of that fall into the category of prescribed securities and also do not qualify for this election. Prescribed securities include the following:
Shares whose value is primarily attributable to real property, or resource property;
Shares whose value is primarily attributable to real property, or resource property;
Non-arm’s length debt;
Shares or debt acquired in a non-arm’s length transaction or in most tax-deferred rollovers;
Exploration and development shares; and
Shares or debt substituted for any of the above.
If shares of a company not resident in Canada or a prescribed property are disposed of, the gain or loss on disposition may still be a capital gain or capital loss. When determining whether the gains and losses of these properties are capital or income in nature, you will have to consider the factors discussed above.
Where making the election is an option, it must be made in your return in the year of disposition. It is important to know that once the election is made, it is effective in the election year and all subsequent taxation years. This means that if you own securities which qualify for the election, once the election is made, those securities will be capital property, and the gains and losses on the disposition of those securities will be capital gains and capital losses. With this in mind, it is very important to consider whether guaranteed capital gains and losses on the disposition of Canadian securities is beneficial for you. If you do not make an election, it does not necessarily mean the Canadian securities you hold will not be considered capital property. The securities will be capital property, unless you meet the criteria for income treatment discussed above. By not making the election, you continue to have the option to claim certain losses on Canadian securities as income losses, which can offset other income, if the losses are in fact not capital in nature.
What investment-related expenses are deductible?
As an investor, you will undoubtedly incur various expenses with respect to your investments. It is not surprising that there are rules which allow the deduction of certain investment-related expenses, but not others. In order to be deductible for tax purposes, expenses must be reasonable and incurred for the purpose of earning income.
You are allowed to deduct certain expenses in respect of earning investment income including interest on money borrowed to purchase investments for the purpose of earning income, fees for the management or safe custody of investments, safety deposit box charges and accounting fees for recording investment income. You will also be allowed to deduct fees paid to a professional investment counsellor for managing your investments and for providing advice on buying and selling specific securities. Discount broker fees or commissions for trades are not a deductible expense. Rather, these fees and any other amounts incurred in the purchase or sale of securities that are capital property are added to the cost base of those securities and are included in the determination of the capital gain or loss when the securities are disposed of. However, where a broker’s principal business also includes investment portfolio management and administration services and a separate fee is charged, that fee will be deductible.
If you are an annuitant of an RRSP or RRIF, amounts you pay for services in respect of an RRSP or RRIF, including administration fees and investment counsel fees, are not deductible for tax purposes.
You may also incur expenses such as newspaper and financial magazine subscription fees, internet connection charges and telephone/long distance charges in order to trade securities. These expenses will not be deductible for tax purposes as they are considered to be on account of capital because they were incurred in connection with the purchase, sale and retention of capital assets. If your trading activity constitutes running a business, then you may be able to deduct the business-related portion of these expenses provided that they are reasonable and incurred to earn income. However, the income earned from this trading activity will not benefit from capital gains treatment as the securities will not be considered capital property.
If you are an active trader in the stock market, it’s important to understand the tax consequences of your trading activities. If you have any questions on the tax treatment of your investment gains and losses, and investment-related expenses, contact your BDO advisor.
With rising stock markets and direct access to the markets through online discount brokers, more and more individuals are managing their own stock portfolios. Some individuals are even active daily, to the point where they only hold a particular stock for a very short period, to benefit from the current movement in the stock price. These individuals, who trade in their portfolio on a daily basis, have become known as “daytraders.” The purpose of this article is to review the tax issues that daytraders face when they report their gains and losses on their income tax returns.
Gains―are they income or capital gains?
For most individuals, any gain they realize when they dispose of a share investment is a capital gain, only a portion of which is taxable. The inclusion rate for capital gains decreased from 3/4ths to 2/3rds for dispositions after February 28, 2000, and to 1/2 for dispositions after October 17, 2000. Generally, capital losses can only be used to reduce capital gains and are deductible at the same inclusion rate that applies to the capital gain.
However, when the level of a person’s stock trading reaches a certain point, the Canada Customs and Revenue Agency (CCRA) may take the view that the gains and losses realized on stock transactions are income gains and losses. In other words, they would argue that the level of trading activity constitutes a business for the individual. This is a particular risk for daytraders.
In determining whether gains and losses are income or capital in nature, a number of factors have to be considered. These include:
Frequency of transactions. If you have a history of extensive buying and selling of securities or a quick turnover of property.
Period of ownership. If you hold securities for a short period of time.
You have some knowledge of or experience in the securities markets.
Securities transactions form part of your ordinary business.
You spend a substantial amount of your time studying the securities markets and investigating potential purchases.
Security purchases are financed primarily on margin or by some other form of debt.
You have advertised or made it known that you are willing to purchase securities.
In the case of shares, the shares are speculative or have low dividend yields.
No one factor will be determinative. However, where a combination of the above factors apply to your situation, the CCRA may consider you to be carrying on a business, so gains will be treated as business income and will be fully taxed. It is important to be aware of these factors, to understand how your gains or losses may be taxed by the CCRA.
Canadian securities―capital gains and losses
The Federal government allows investors to make an election to tax gains and losses from Canadian securities as capital gains and losses. If you qualify for this election, it can add certainty to characterizing gains and losses as capital in nature. You will qualify to make this election if you invest in Canadian securities and if you are not a “trader or dealer in securities,” or a non-resident. You will be considered a “trader or dealer in securities” if you participate in the promotion or underwriting of an issue of shares, bonds or other securities or you hold yourself out to the public as a dealer in these securities. As well, if you utilize special knowledge of a corporation not available to the public to realize a quick gain, you will be considered a “trader or dealer in securities” for those particular securities.
For the purpose of making this election, Canadian securities include shares of the capital stock of a corporation that is resident in Canada, a unit of a mutual fund trust or a bond, debenture, bill, note, mortgage or similar obligation issued by a person resident in Canada. Options, commodities and commodity futures do not qualify however.
In addition, it is important to note that foreign securities do not qualify for this election?it is common for most investors these days to trade in stocks of companies that are not resident in Canada. For these securities, this election provides no protection. As well, there are certain securities that you should be aware of that fall into the category of prescribed securities and also do not qualify for this election. Prescribed securities include the following:
Shares whose value is primarily attributable to real property, or resource property;
Shares whose value is primarily attributable to real property, or resource property;
Non-arm’s length debt;
Shares or debt acquired in a non-arm’s length transaction or in most tax-deferred rollovers;
Exploration and development shares; and
Shares or debt substituted for any of the above.
If shares of a company not resident in Canada or a prescribed property are disposed of, the gain or loss on disposition may still be a capital gain or capital loss. When determining whether the gains and losses of these properties are capital or income in nature, you will have to consider the factors discussed above.
Where making the election is an option, it must be made in your return in the year of disposition. It is important to know that once the election is made, it is effective in the election year and all subsequent taxation years. This means that if you own securities which qualify for the election, once the election is made, those securities will be capital property, and the gains and losses on the disposition of those securities will be capital gains and capital losses. With this in mind, it is very important to consider whether guaranteed capital gains and losses on the disposition of Canadian securities is beneficial for you. If you do not make an election, it does not necessarily mean the Canadian securities you hold will not be considered capital property. The securities will be capital property, unless you meet the criteria for income treatment discussed above. By not making the election, you continue to have the option to claim certain losses on Canadian securities as income losses, which can offset other income, if the losses are in fact not capital in nature.
What investment-related expenses are deductible?
As an investor, you will undoubtedly incur various expenses with respect to your investments. It is not surprising that there are rules which allow the deduction of certain investment-related expenses, but not others. In order to be deductible for tax purposes, expenses must be reasonable and incurred for the purpose of earning income.
You are allowed to deduct certain expenses in respect of earning investment income including interest on money borrowed to purchase investments for the purpose of earning income, fees for the management or safe custody of investments, safety deposit box charges and accounting fees for recording investment income. You will also be allowed to deduct fees paid to a professional investment counsellor for managing your investments and for providing advice on buying and selling specific securities. Discount broker fees or commissions for trades are not a deductible expense. Rather, these fees and any other amounts incurred in the purchase or sale of securities that are capital property are added to the cost base of those securities and are included in the determination of the capital gain or loss when the securities are disposed of. However, where a broker’s principal business also includes investment portfolio management and administration services and a separate fee is charged, that fee will be deductible.
If you are an annuitant of an RRSP or RRIF, amounts you pay for services in respect of an RRSP or RRIF, including administration fees and investment counsel fees, are not deductible for tax purposes.
You may also incur expenses such as newspaper and financial magazine subscription fees, internet connection charges and telephone/long distance charges in order to trade securities. These expenses will not be deductible for tax purposes as they are considered to be on account of capital because they were incurred in connection with the purchase, sale and retention of capital assets. If your trading activity constitutes running a business, then you may be able to deduct the business-related portion of these expenses provided that they are reasonable and incurred to earn income. However, the income earned from this trading activity will not benefit from capital gains treatment as the securities will not be considered capital property.
If you are an active trader in the stock market, it’s important to understand the tax consequences of your trading activities. If you have any questions on the tax treatment of your investment gains and losses, and investment-related expenses, contact your BDO advisor.
