Business Income vs. Capital Gains
So how do you determine the difference between capital property and inventory? Here are three things to keep in mind:
- The normal course of business:
If the transaction is similar to the normal course of business, it may be considered business income. - The frequency of the transaction:
The more frequently you engage in the transaction in question, the more likely the CRA will consider it on account of business. - The adventure in the nature of the trade:
Income from an adventure or concern in the nature of trade is treated like business income. If what you are doing is an "adventure in the nature of trade," then your gain will be fully taxable.
You can determine if the transaction is an adventure or concern in the nature of trade by:
- Whether you've dealt with the property in the same way as a dealer ordinarily would;
- Whether the nature and quantity of the property excludes the possibility that its sale was of a capital nature; and
- Whether the taxpayer's intention is consistent with the other two tests pointing to a trading motivation. If the primary intention is said to be the holding of the property as an investment, CRA considers if there was a secondary intention to sell the property when the primary intention could not be fulfilled.
Shares
CRA generally accepts that most people hold shares of corporations and other securities, such as bonds and mutual fund units, as capital property. Capital gain or loss is subject to preferred tax treatment whereby only 50% of the gain is included in income and taxes.
However, if you trade shares on a regular basis and hold them for only short periods, you might be found to be in business, in which case your gains would be fully taxable.
You can avoid this situation by filing a "Canadian securities election" on Form T123 with your tax return, so that all Canadian securities you hold are deemed to be capital property, forever.
Real estate
As you can imagine, the most difficult issues with regards to business or capital income usually arise with respect to real estate. You might build a home to live in (capital), but also with plans to sell it (inventory). Paragraph 3 of the CRA's Interpretation Bulletin IT-218R sets out 12 factors that the CRA considers relevant in determining the intention with respect to the property. The courts also have developed the concept of a "secondary intention," as discussed above.
Principal residence
The gain on a principal residence is normally completely exempt from tax. Many small homebuilders have tried building a home, moving in, selling it, and moving on to another home, repeating the process a few times. If you do this, the CRA will determine that you do not have an exempt capital gain after all. Instead, you are treating each home as "inventory," and you will be fully taxed on the gain as business profit.
Note: If you haven't kept all of your receipts for the costs of construction, you might have a hard time proving that your profit was less than what the CRA claims it was! You might also be required to pay GST or HST on the entire value of the new home.
The CRA has been known to go after builders even 10, 15, or 20 years. If you are in this situation, consider making a Voluntary Disclosure before CRA comes calling.
For more information on salary, dividend, and compensation strategies, you can reference CPABC Tax Tips. If you have any questions about such compensation, be sure to contact Sidhu & Associates chartered professional accountant.
FAQs
Capital Gains. The distinction between whether a transaction is on account of business or on account of capital is important because business income gets included in income at 100% whereas capital gains are only included in income at 50%.
Is capital gain considered as business income? ›
The gains arising from sale of shares or securities can be treated either as capital gains or business income. Determining the gains from shares/securities as capital gain or business income is a fact specific and it has led to a lot of uncertainty and litigation in the past.
What is the difference between business profit and capital gains? ›
Is it business income or capital gain? The distinction is important because business income (or loss) gets included in income at 100%, whereas a capital gain (or loss) is only included in income at 50%.
What is the difference between income and capital gains? ›
Capital gains and other investment income differ based on the source of the profit. Capital gains are the returns earned when an investment is sold for more than its purchase price. Investment Income is profit from interest payments, dividends, capital gains, and any other profits made through an investment vehicle.
What are examples for a business of capital income? ›
Capital income is income received from non-regular (one-off) transactions. The main example is the income generated from the sale of non-current assets. Other examples are loans received by the business and capital invested in the business by the owner or owners of the business.
What is taxed more income or capital gains? ›
The most important thing to understand is that long-term realized capital gains are subject to a substantially lower tax rate than ordinary income. This means that investors have a big incentive to hold appreciated assets for at least a year and a day, qualifying them as long-term and for the preferential rate.
How much profit is considered capital gains? ›
When you sell an investment at a profit, the difference between the selling price and the purchase price (a.k.a cost basis) is considered a capital gain.
Is selling a business capital gains or ordinary income? ›
In California, the profits you get from selling your business will count as capital gains. Even if you sold your business for a low price (under $10,000), you would still be subject to a taxable income rate of 1%.
How do you calculate capital gains on a business? ›
The calculation of capital gains on the sale of a business is relatively straightforward. You simply multiply the gain (the proceeds from the sale minus your basis in the business) by the capital gains tax rate.
How can I avoid paying capital gains tax? ›
An easy and impactful way to reduce your capital gains taxes is to use tax-advantaged accounts. Retirement accounts such as 401(k) plans, and individual retirement accounts offer tax-deferred investment. You don't pay income or capital gains taxes at all on the assets in the account.
This tax is applied to the profit, or capital gain, made from selling assets like stocks, bonds, property and precious metals. It is generally paid when your taxes are filed for the given tax year, not immediately upon selling an asset.
Are capital gains taxed twice? ›
The taxation of capital gains places a double tax on corporate income. Before shareholders face taxes, the business first faces the corporate income tax.
Are business profits considered capital gains? ›
Your profits will count as capital gains if you sell your customer lists, goodwill, or other intangible assets. For this reason, keeping a log of all intangible assets you plan to sell when selling your business is a good idea.
What is business income? ›
Business income may include income received from the sale of products or services. For example, fees received by a person from the regular practice of a profession are business income. Rents received by a person in the real estate business are business income.
Is capital gain qualified business income? ›
QBI does not include items such as: Items that are not properly includable in taxable income. Investment items such as capital gains or losses. Interest income not properly allocable to a trade or business.
