30 October 2012 Ontario CTF Roundtable Q. 14, 2012-0462941C6 - 2012 Ontario CTF Q14 - Circularity with 164(6)

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: The CTF has asked how CRA would administer subsection 164(6) where a circularity issue arises in applying subsection 40(3.61).

Position: We recognize that the circularity issue exists on a technical reading of 40(3.6), 40(3.61) and 164(6). CRA will review on a case-by-case basis.

Reasons: To date, we have never had an actual case referred to our directorate.

Ontario CTF Conference – October 30, 2012

Question 14

There can be an issue when an estate elects under subsection 164(6) to apply a capital loss to the terminal return of the deceased. It is possible to create "circularity" under 164(6), when an estate carries back a loss but then realizes a capital gain on other assets in its first taxation year. See Nick Moraitis and Manu Kakkar's Taxfind article "Potential Circularity Problem with Estate Loss Carryback" published by the CTF. How would CRA interpret 164(6) in such circumstances? Would you administratively ignore subsections 40(3.6) and 40(3.61) when determining the net capital loss for purposes of 164(6)?

CRA Response

Subsection 164(6) of the Act allows the estate of a deceased taxpayer to elect to have all or part of its capital losses (to the extent they exceed its capital gains) that are realized in its first taxation year to be deemed to be capital losses of the deceased. The election, which results in the carry back of the elected amount to the final return of the deceased, can be useful in addressing potential double taxation which may arise where the deceased held corporate shares with accrued gains at death.

Subsection 40(3.6) of the Act is a stop-loss rule that applies if a taxpayer disposes of a share of a corporation to the corporation, and the taxpayer is affiliated with the corporation immediately after the disposition. When subsection 40(3.6) applies, the taxpayer's loss from the disposition is deemed to be nil. Prior to the introduction of subsection 40(3.61), if the estate and the corporation were affiliated immediately after the disposition (typically, on the redemption of the shares by the corporation), the capital loss would be stopped, and could not be carried back to be applied on the terminal return.

In general, subsection 40(3.61) was introduced to override the effect of the stop-loss rules in subsections 40(3.4) and (3.6) where an estate's capital loss is being carried back pursuant to subsection 164(6). Subsection 40(3.61), which applies if the estate elects pursuant to subsection 164(6) in respect of a capital loss on the disposition of a share of a corporation, provides that subsections 40(3.4) and (3.6) apply "in respect of the loss only to the extent that the amount of the loss exceeds the portion of the loss to which the election applies".

We have reviewed the article referred to in your question and agree, based on a technical reading of the above provisions that it is possible for a circularity issue to arise. If the estate realizes capital gains during its first taxation year, those gains must be applied against the loss on the share disposition, in accordance with the requirements of subsection 164(6), in order to determine the amount that can be carried back. Where this occurs, the application of 40(3.61) will result in an amount of loss stopped pursuant to subsection 40(3.6), which in turn will reduce the amount available for the 164(6) election, and the circular nature of these provisions becomes an issue.

To date, however, the Income Tax Rulings Directorate has not been informed of an actual case in which this issue has arisen. We suspect that the incidence of this potential circularity issue is likely quite limited, for a number of reasons:

1. One would expect that typically, estates should not realize significant gains in their first taxation years, as assets acquired at the time of death would generally be acquired at fair market value pursuant to subsection 70(5) of the Act.
2. The ability to distribute assets of the estate to its beneficiaries on a rollover basis pursuant to subsection 107(2), where applicable, would avoid the generation of gains in the estate in respect of such asset dispositions.
3. Given that the issue was identified in the above-referenced article, many practitioners are no doubt aware of it and are ensuring that capital gains are deferred beyond the first taxation year of the estate.

We would appreciate if any of your members encounter such an example, that it be provided to CRA, so that we can review the issue further on a case-by-case basis.

Phil Kohnen
2012-046294
October 30, 2012