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1. Capital gains, non-residents and migrants

This chapter describes how Canada's income tax law currently treats capital gains. An understanding of the existing rules is necessary in order to understand Canada's tax policy regarding taxpayer migration.

In describing the existing law, this chapter uses plain language as much as possible. Unavoidable technical terms are highlighted and defined in an appendix. To improve readability, the text does not include specific legal references such as Income Tax Act section numbers. It is much more important that non-specialist readers understand the general substance of the rules discussed than their mechanical details. Those who wish to compare these descriptions to the technical language of the statute itself can find ample citations in the published transcripts of the Committee's hearings.

(a) Capital gains, non-residents and taxable Canadian property

(i) description

Largely for historical reasons, traditional tax theory distinguishes between ordinary income and capital gains (1). When a taxpayer disposes of a property, any excess of the taxpayer's proceeds of disposition over what the property cost is ordinary income if the property is inventory, and a capital gain if the property is a capital property. Inventory is property acquired with the intention of reselling at a profit; capital property includes property acquired to generate income (such as rent or interest) and property acquired for non-income-earning purposes. For individuals, the most common capital properties are houses and other real estate, securities such as stocks, bonds and mutual fund investments, and business property such as a tradesperson's tools.

1 - Terms in bold type are defined in Appendix A.

Since 1972 Canada's Income Tax Act (2) has taxed residents of Canada on their taxable capital gains from all sorts of capital property (with exceptions such as the $500,000 exemption for small business owners and farmers and the exclusion of most personal-use property).

2 - RSC 1985 (5th supp.), c.1, as amended.

Ordinarily, capital gains are taxed on realization - that is, when the owner has sold the property and has realized the gain. In a few special situations, the Act treats an owner as having sold a property even though the owner has not in fact done so. The most common of these deemed dispositions applies where an individual dies. The deceased person is taxed as though every capital property she or he owned had been disposed of just before death. A deemed disposition ordinarily has the effect of taxing any accrued gains, whether or not the taxpayer has actually realized them.

Non-residents of Canada are taxable under the Act on their capital gains on several sorts of property situated in Canada. The Act defines these sorts of property as "taxable Canadian property" (TCP). The most important kinds of TCP are Canadian real estate and the shares of Canadian private corporations. More specifically, the Act's definition of TCP includes the following: (3)

3 - Proposed amendments to the definition, which were originally released by the Department of Finance in April, 1995 and introduced, with some changes, in a Notice of Ways and Means Motion tabled by the Minister of Finance in June of this year are not included in this list. The most important changes add shares in certain non-resident corporations and interests in certain non-resident trusts to the list.

(ii) policy basis

Most Canadians would probably accept as a given that non-residents who realize gains on Canadian property should be subject to Canadian tax. The definition of TCP attempts to draw an appropriate line around those properties that are to be considered "Canadian" for this purpose.

If tax revenues from non-residents were the only consideration, TCP would be defined as broadly as possible. At the extreme, every property on which a taxpayer might conceivably generate a gain would be listed, whether or not that property had any connection to Canada. Every non-resident of Canada would in principle be taxable in Canada on every gain.

As it stands, the more limited TCP definition reflects three other policy considerations. First, there are limits to how long a tax reach any country can justify. Canada can not easily argue that it has a right, under general taxation principles, to tax non-residents' gains on property with no connection to Canada. The TCP definition thus includes only those sorts of property that Canada considers it can justifiably tax.

Second, the TCP definition reflects the practical limits on non-residents' ability to comply with, and on Revenue Canada's ability to enforce, a tax liability. Real property situated outside of Canada, for example, is not TCP. Even if Canada could justify asserting a right to tax gains on such property, it would be difficult or impossible to detect a transaction between non-resident parties with respect to the property, to inform them that the seller (and, in the event of the seller's failure to comply, the buyer) was liable for Canadian tax, and to enforce any sanctions upon either party in the event that they chose to ignore their Canadian income tax obligations.

Third, the TCP definition must be appropriate not only for permanent non-residents, but also for taxpayers who move into or out of Canada. As discussed below, under Canada's current system, an emigrant is generally required to pay tax on any gains that have accrued on non-TCP. Since the emigrant has not actually disposed of the property, however, there can arise a mismatch between the tax liability and the emigrant's practical ability to pay. Immigrating taxpayers, meanwhile, are not treated as having disposed of their TCP, and are taxable in Canada on both pre- and post-immigration gains. The dividing-line between TCP and other property is thus relevant for a significant number of taxpayers other than permanent non-residents.

Whatever form it takes, any definition of the property in respect of which Canada will tax a non-resident's gain must take account of all of these factors. The list of property treated as TCP has to be limited to types of property which have a connection with Canada sufficient both to support Canada's right to tax, and also to fall within Canada's ability to tax. (4) It also has to make sense not only for non-residents, but also for taxpayers whose residence changes.

4 - The Committee is aware of concerns with respect to the scope of the amendments described in note 3 above, which it will be able to consider when those amendments are brought before it. However, the Committee has seen no evidence to suggest that the current definition of TCP, or the proposed amendments to that definition, includes property of non-residents which Canada ought not or realistically cannot attempt to tax.

(b) Emigrants

(i) description

The income tax effect of ceasing to be resident in Canada is different for different kinds of taxpayers. Individuals other than trusts, trusts and corporations are all subject to special rules.

The Act treats an individual emigrant as having disposed of all the emigrant's property other than TCP - and thus as having realized any accrued gains on that property. Canada retains the right to tax TCP in the hands of a non-resident. This allows an exception to be made for an emigrant individual's TCP. An emigrant who owns a summer cottage in Canada, for example, will not pay tax on the property's appreciated value at the time of emigration, but will be taxed on an ultimate disposition of the cottage.

For the purposes of this deemed disposition, the Act allows an individual emigrant to choose to treat any capital property that is not TCP as though it were TCP. This means that the emigrant will not immediately be taxed on the gain that has accrued to that time, but will face Canadian tax (subject to treaty) when the property is actually disposed of. To ensure that Canada collects its tax at that later time, the emigrant must give Revenue Canada security for the tax that would have been payable if the property were not treated as TCP. Similarly, an emigrant individual can choose to be treated as having disposed of any particular property that is TCP. An emigrant who had, for example, an accrued gain on a property that was not TCP, and an accrued loss on TCP, might choose to offset the two by being treated as having disposed of both properties.

The Act considers a trust an individual. Most of the rules described here as applying to individual emigrants thus apply to trusts as well as to natural persons. (5) A trust cannot, however, choose to defer the recognition of gains on non-TCP, or elect to be treated as having disposed of TCP on emigration. There is also a special rule that applies if a trust distributes capital property to a non-resident beneficiary. In that case, the trust is treated as having disposed of the property (and therefore must pay tax on any accrued gain), unless the property is TCP. If it is TCP, the beneficiary will (subject to treaty) face Canadian tax when the beneficiary disposes of the property.

5 - Trusts are generally residents of the country where their trustees reside. A trust can therefore emigrate by replacing trustees in one country with trustees in another.

It is possible, but quite rare, for a corporation to become or cease to be resident in Canada. Corporations that leave Canada are treated as having disposed of all of their property, with no exceptions. They also pay a special tax on any retained earnings they remove from Canada.

In summary, natural persons thus have the greatest flexibility in arranging their tax affairs upon emigration; they can recognize gains on any property they wish, and they can defer gains on any property they wish. Choosing to recognize gains on TCP at the point of departure will not, however, prevent post-departure gains on that property from being taxable when the property is ultimately sold. Similarly, an election to defer gains on non-TCP at the point of departure means remaining taxable on both pre- and post-departure gains.

Trusts are not permitted to advance or defer the recognition of gains on emigration. Pre-departure gains on non-TCP are always taxable when a trust ceases to be a Canadian residence, and post-departure gains on such property are always exempt. Both pre- and post-departure gains on TCP are taxable when the trust ultimately disposes of the property in question. Corporations are taxable on emigration on the gains accrued on all of their property up to the point of departure, and are also subject to tax on post-departure gains on TCP when it is ultimately sold.

(ii) policy basis

The general policy principles that underlie these rules seem evident. Pre-departure gains are generally taxable on emigration. Where they are not -- as in the case of TCP for all individuals and electively deemed TCP for natural persons -- both the pre-departure and any post-departure gains on the property will be subject to tax on its ultimate disposition.

If the option or right of deferral provided to individual emigrants is based on the assumption that the property will be subject to tax by Canada when it is later sold, then the effect of Canada's tax treaties on Canada's ability to tax raises significant policy questions. These are discussed separately below.

(c) Immigrants

(i) description

When a non-resident moves to Canada, the Act treats the non-resident as having disposed of and reacquired all property other than taxable Canadian property immediately before becoming resident. This deemed disposition ensures that Canada taxes the new resident's gains on non-TCP only to the extent those gains arose while a resident of Canada. The exclusion of TCP from the deemed disposition, on the other hand, ensures that Canada taxes the new resident on the full amount of any eventual gain on that property.

In addition to these general rules, the Income Tax Act includes a special exception, for recent immigrants, to the foreign trust rules. These rules are extremely complex, but their general effect is quite straightforward. Canada ordinarily taxes, either directly or in the hands of the beneficiaries, the income of a foreign trust settled by a person for the benefit of the person or related Canadian-resident beneficiaries. The exception exempts from this rule any trust created by a person who has been resident in Canada for 5 years or less.

(ii) policy basis

The general rules for immigrants reflect a policy of taxing only post-immigration gains, except where a gain arises on property that was taxable by Canada while the taxpayer was a non-resident. In the latter case, both the pre- and the post-immigration gain will be subject to tax when the former non-resident disposes of the property.

The rules for immigrants are thus symmetrical to those for emigrants. In both cases, a migrant taxpayer's gain on non-TCP is divided into a non-resident and a resident component, with Canada taxing only the gain that arose in Canada. Similarly, both immigrants and emigrants remain fully taxable on their gains on TCP, since those gains are taxable regardless of where the taxpayer who realizes them resides.

The special five-year exception for immigrants' foreign trusts would appear to be designed to facilitate immigration. The Committee did not hear evidence suggesting that this exception is inappropriate.

(d) The effect of tax treaties

Canada has nearly 60 bilateral tax treaties with other countries. These treaties have a significant effect on the practical application of the rules and policies described to this point.

The purpose of tax treaties is to prevent fiscal evasion and to eliminate double taxation. Double taxation is generally eliminated in one of two ways. The first way is for either the country in which the income is generated (the "source state") or the country in which the taxpayer resides (the "residence state") to be given exclusive taxation rights over the type of income in question. The second way is to allow both countries the right to tax the income (often with a limit on the maximum rate of tax the source state can apply), and to require the residence state to provide credit for the source state's tax against the residence state's tax on the income.

Canada's tax treaties place significant limits on Canada's (and our treaty partners') right to tax gains on property disposed of by residents of the other treaty country. In general, the treaties allow Canada to tax the gains of Canadian residents from dispositions of property situated in the other country, but limit Canada's right to tax gains of the other country's residents to:

The terms of these treaties are fully bilateral: the other country is entitled to tax its residents on all gains from dispositions of Canadian property, but can tax Canadian residents only on the same types of property in respect of which Canada is entitled to tax that other country's residents.

This means that of the ten types of property falling within the TCP definition set out above, only Canadian real property and Canadian business property are always taxable by Canada when disposed of by residents of treaty countries. Interests held by treaty country residents in Canadian and foreign corporations, partnerships and trusts are taxable by Canada, if at all, only if the greater part of their value comes from Canadian real property.

In other words, many properties which the Act describes as being taxable in Canada when disposed of by a non-resident are in fact not taxable if the non-resident in question is a resident of a treaty country. This does not mean that Canada loses by its treaties: the treaties give Canada the same exclusive taxation rights over its own residents that it concedes to its treaty partners over theirs. It does, however, have certain implications for the taxation of immigrants to and emigrants from Canada.

As noted above, Canada permits individuals, other than trusts, who emigrate from Canada to defer tax on pre-departure gains on all property, and allows trusts to defer tax on pre-departure gains in respect of TCP. The Act further provides that all gains on such property are subject to tax when it is later sold -- that is, after the taxpayer has become a non-resident. If an emigrant from Canada, having chosen to defer the recognition of pre-departure gains on a given property, takes up residence in a country with which Canada has a tax treaty, and postpones disposing of the property long enough to avoid any treaty right Canada may have to tax former residents, (6) the Canadian tax deferred at the time of emigration may be avoided altogether.

6 - A large number of Canada's treaties allow Canada to tax former residents on gains on some or all types of TCP for a fixed period after leaving Canada.

Whether it is the taxpayer or the fisc of the other country that gains from Canada's not having taxed the property will depend on that other country's laws. If they are like Canada's, and give an immigrating taxpayer a tax cost for the property equal to its value at the time of immigration, the taxpayer will reap the savings himself. Similarly, if the other country does not tax its residents on capital gains, the taxpayer wins. If the other country taxes new residents on the full difference between their proceeds of disposition and their original cost of a property, the taxpayer will be no further ahead (assuming comparable tax rates). Instead, Canada's potential tax revenues will have gone to the new country of residence.

In the case of an immigrating taxpayer, the interaction of Canada's domestic rules and our tax treaties is more equivocal. On the one hand, excluding TCP from the immigrant's deemed disposition means that some pre-immigration gains that a treaty would exempt from Canadian tax may be subject to tax here. On the other hand, it is not a treaty but the Act itself that prevents Canada from taxing the new resident's pre-immigration gains on non-TCP.

(e) Reporting and collection requirements

As noted above, the Income Tax Act's definition of taxable Canadian property is based largely on a practical recognition of the limits to Revenue Canada's ability to collect Canadian income tax from non-resident taxpayers. Even in a self-assessing tax system, where taxpayer compliance is assumed, effective tax collection requires the revenue authority to have the fullest information possible about taxpayers' holdings and activities. This need for information is particularly acute where non-resident taxpayers -- or the foreign holdings of Canadian taxpayers -- are involved.

Closely related to the need for information is the need for special collection techniques where non-residents are concerned. In many transactions involving a non-resident vendor of Canadian property, the Canadian government can much more reliably collect tax from the purchaser than from the vendor. This is especially the case where the purchaser is a Canadian resident. It is the resident party to the transaction, not the Government of Canada, that can best collect from the non-resident. This suggests that responsibility for collection ought in some cases at least to lie with the resident party to a cross-border transaction.

The Act does impose some information reporting requirements on non-residents, and does hold purchasers liable in certain transactions for tax owed by their non-resident counterparts. These obligations arise on the sale of most forms of taxable Canadian property by a non-resident of Canada. Since the non-resident vendor will face Canadian tax on any resulting capital gain, the vendor is generally required to inform Revenue Canada of the transaction within 10 days following the sale, if notice has not been given beforehand. The non-resident vendor must also make a payment (or provide security acceptable to Revenue Canada) on account of the income tax liability arising from the sale. Otherwise, the purchaser may be liable for the payment.

In practical terms, these rules mean that a resident of Canada who buys Canadian real estate or other taxable Canadian property (other than "excluded property" (7)) from a non-resident must either verify that the vendor has cleared the transaction with Revenue Canada, or run the risk of having to pay a portion of the sale proceeds to the Canadian government.

7 - The rules described here do not apply to "excluded property." Excluded property includes property that is deemed (as op posed to actual) TCP, shares of public corporations, mutual fund units, and various financial instruments.

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