Many disputes arise over whether a gain from a sale should be treated as “business income” or “capital gain”. This is a common subject of tension between taxpayers and CRA because only half of a capital gain is taxable, while the full amount of business income is taxable. A common metaphor to illustrate the difference between the two types of income is a tree that bears fruit; the tree is the capital property and the profit from the fruit produced is business income. Selling the tree would create a capital gain, unless someone was in the business of selling trees – then the profits would be taxed as business income. In reality, making a determination between the two types of income can be difficult and is often subject to much interpretation.
A number of factors are relevant to a determination of the type of income that arises from a disposition, but the main consideration is the intention at the time the property was purchased. Generally speaking, a taxpayer’s intention is considered alongside two other tests: whether the taxpayer dealt with the property in the same way a dealer or trader would, and whether the nature and quantity of the property requires that the sale be that of a business or trading nature. Applied to the fruit tree analogy, if someone has been actively advertising trees for sale and has purchased a large quantity of trees without harvesting any of the fruit, it is unlikely that their intent was to harvest and sell the fruit; accordingly a sale of the tree should be on income account.
For example: a condominium unit is purchased with the intention of renting it out and creating a stable source of income. For any number of reasons (job relocation, unexpected unemployment, better investment opportunities elsewhere, marriage, enrollment in education, to name a few) the unit must be sold before anyone has rented it, or perhaps has rented it for only a short period of time. How should the gain on this sale be reported on the individual’s tax return?
Another common example: the same condominium unit was purchased by an individual with the intention of living there, but for any of the reasons described above, the individual realizes that they cannot fulfil this intention and as a result, the unit is sold and the individual has either not lived there at all or has lived there for only a short period of time. How should the gain on this sale be reported? Can the individual take advantage of the tax free principal residence exemption?
The sales in the two above examples should arguably be characterized as (1) a capital gain, and (2) a capital gain with the principal residence exemption available. Unfortunately, CRA is commonly challenging those characterizations (condo flippers beware), and the burden of proof is on the taxpayer to establish a prima facie (meaning “at first sight”) case that CRA was wrong. In fact, many taxpayers are not aware that the initial onus is on them to support their argument – unlike criminal law, a taxpayer is not “innocent until proven guilty” due to the presumption that the taxpayer has better access to information which substantiates their position, relative to CRA. The CRA has very braod powers to compel a taxpayer to provide information. Of course, this is often not the case, and it becomes very difficult for a taxpayer without proper documentation to convince CRA of their original intention. In the case of real estate, CRA’s interpretation bulletin IT-218R describes a number of factors that will be considered in determining whether a sale was on account of income or capital.