COVID-19: Beware of superficial losses!

David Truong, CIWM, Pl.Fin, M.Fisc., National Bank, Private Banking 1859

The recent sharp drop in the stock markets has hit us hard. This is going to be a difficult time for everyone, in addition to the health consequences of COVID-19. In an ideal financial context, clients should remain invested and rational. But the reality is quite different: some of our clients let themselves be guided by their emotions such as anxiety or fear, and decide to sell their investments, which means taking losses for some.

History has taught us that a period of stock market turbulence is normally followed by an economic recovery. When does this happen? No one knows. But when recovery is imminent, taxpayers must be careful about the superficial loss rules if they decide to jump on financial market bargains.

Superficial losses for an individual

Generally, the loss will not be deductible to an individual if it qualifies as a "superficial loss". For a loss to qualify as a "superficial loss", the following two conditions must be met:

• an identical property is acquired by either an individual or an affiliated person during the period beginning 30 days before the disposition and ending 30 days after the disposition; and
• the identical property is still held by the purchaser 30 days after the disposition.

Consequently, the amount of the denied loss will be added to the adjusted cost base (ACB) of the security of the purchaser, either the same person or an affiliated person. An affiliated person of an individual includes a spouse, a corporation controlled by the individual or the individual's spouse, a partnership in which the individual has a controlling interest, or a trust of which the individual is a majority-interest beneficiary (RRSP, RRIF, TFSA, etc.).

Here's an example:

Assuming the mutual fund units are still held after 30 days, the loss of $3,000 ($7,000 - $10,000) is an superficial loss. Therefore, it will be denied and added to the ACB of the units acquired as of March 21, for a total of $9,000 ($6,000 + $3,000).

On the other hand, if the number of units of the identical property is not the same as the number of units disposed of, a proportionality rule applies. For example, if only one unit of XYZ had been purchased on March 21, the denied loss would be only $3, and would have been added to the ACB of the one unit, for a total of $9 ($6 + $3).

Also, if the XYZ units acquired on March 21, 2020 were held in an RRSP instead of an unregistered account, the loss would also be denied, but since any withdrawal from the RRSP is taxable, the ACB adjustment would be useless.

Note that there are situations where one wants to transfer a loss to an affiliated person, such as a spouse. Among other things, it is important to make sure that the conditions are met, especially if the spouse holds the identical property after 30 days.

The issue is to be able to demonstrate that two properties are, in fact, identical. However, the Income Tax Act says that a bond, debenture, note, or other comparable security issued by a debtor is identical to another similar security issued by that debtor if the two have the same rights (such as a conversion right), except for the principal amount.

With respect to shares, the Canada Revenue Agency has provided some technical interpretations on this subject:

• Shares of a corporation are identical if they belong to the same class.
• Shares of two different classes of the same corporation are not considered identical, even though shares of one class may be exchanged for shares of the other class or may be converted into shares of the other class (e.g., ATD.A and ATD.B are not identical properties).
• Mutual fund units are identical only if they are issued from the same fund or have the same components (TSE 300 and TSE 60 are not identical properties but a similar fund from two different suppliers could be identical properties).

Superficial losses for a corporation, trust, or partnership

The superficial loss rule is very similar for a corporation, trust or partnership. A loss is also denied, but unlike an individual's loss, it is not added to the ACB of the new identical property. Instead, the deduction of the loss is suspended, and will only be available if it is no longer held by a person in the affiliated group. The concept of affiliated person in this case refers in particular to the majority shareholder of the corporation and the beneficiaries of the trust.

Consider the following example where there are transactions in a corporation and only one shareholder:

Since it is a superficial loss, the $5,000 loss will be denied to the corporation, but it will not be added to the ACB of the subsequent purchase by the shareholder. Thus, the $5,000 loss is suspended, and can be used by the corporation only where neither the transferor nor an affiliated person holds identical property. The loss cannot be transferred to an affiliated person. The loss is therefore confined to the corporation.

When one is sick, confinement is fine, but not for tax purposes.