ETF Taxation: Tax-loss Selling and Identical Property

Tax-loss selling

Tax-loss selling is a popular strategy for making use of capital losses in non-registered investment accounts. The losses can be used to help offset capital gains realized elsewhere in a portfolio. As well, to the extent that capital losses exceed capital gains in a given calendar year, the residual net capital loss may be used to offset capital gains in any of the three previous tax years or carried forward for use in any future year. CRA form T1A, Request for Loss Carryback, is used to carry back capital losses to a prior year.

There’s a challenge with this strategy, however, since-realizing a capital loss could mean selling a security that plays an important role in your portfolio. ETFs can be used to maintain exposure to a particular asset class while allowing for claimable capital losses.

To implement a tax-loss selling strategy, an investor would trigger a capital loss¹ by selling an individual security, mutual fund or ETF that has declined in value relative to their purchase price. If the investor wants to remain invested in that segment of the market, they would subsequently acquire a different yet similar security, mutual fund or ETF. If the investor wants to claim the capital loss, then upon purchasing a new investment, they should be careful not to acquire a security that is identical to the security sold. If the security is deemed identical, the Income Tax Act’s (ITA) superficial loss rule will apply, denying the capital loss claim.

A superficial loss is defined as “the taxpayer’s loss from the disposition of a particular property where…30 days before and 30 days after the disposition, the taxpayer or a person affiliated with the taxpayer acquires a property that is identical…”². For the purposes of this rule, affiliated persons normally include the taxpayer’s spouse, common-law partner, RRSP, RRIF and TFSA, among other corporate, partnership and trust relationships.

 When an investor sells a security or fund that has depreciated in value and then acquires the same security or fund – i.e., identical property – within 30 days before or 30 days after the sale, the loss would be deemed superficial and denied for tax reporting purposes. The loss would be added to the adjusted cost base (ACB) of the repurchased investment, deferring use of the capital loss until the repurchased investment is sold. The purpose of the rule is to prevent investors from triggering capital losses expressly for tax-reduction reasons without a genuine intention of disposing the investment. Here’s an example to consider:

Cliff purchased 3,000 shares of XYZ Emerging Markets ETF on August 10 for $30,000 ($10 per share). Thinking about capital loss planning, on October 11, Cliff sold all shares of the fund for proceeds of $24,000 ($8 per share), resulting in a capital loss of $6,000 (3,000 shares sold, with a loss of $2 per share). Wanting to participate in a potential positive turn in XYZ’s value, three days later, on October 14^th, Cliff bought back 3,000 shares of XYZ Emerging Markets ETF at $8 per share and continued to hold the shares for the remainder of the year.

Since Cliff repurchased identical property within 30 days of the October 11 sale, his capital loss is deemed superficial and not claimable for the year. Instead, his $6,000 loss would be added to the ACB of the repurchased shares ($24,000 + $6,000 = $30,000), allowing for the loss to be claimed in the future when the repurchased shares are eventually sold (assuming the superficial loss rule is not triggered at that time).

Identical property

When it comes to the superficial loss rule, the CRA takes a “question of fact” approach to determining if two properties are identical. In other words, the CRA would review the details of the particular case and form an opinion based on the facts. Regarding the sale and purchase of mutual funds and ETFs, if the underlying investments for two funds are not identical, it’s likely that the sold and purchased funds would not be considered identical properties, and thus, no superficial loss. If the underlying securities are identical, the superficial loss rule may apply. The CRA has defined identical properties as follows:

“Identical properties...are properties which are the same in all material respects, so that a prospective buyer would not have a preference for one as opposed to another."³

The CRA went on to say the following in a technical interpretation document:

“Subject to an analysis of all the relevant facts, in our view, a TSE 300 Index Fund, for example, would generally not be considered identical to a TSE 60 Index Fund. Whether any other investment instruments are identical properties is a question of fact...An investment in a TSE 300 index-based mutual fund of a financial institution would, in our view, generally be considered identical to an investment in a TSE 300 index-based mutual fund of another financial institution.”⁴

Understanding that the question of identical properties is a question of fact, it’s often possible to trigger a capital loss while maintaining exposure to a particular sector, industry or asset class by switching between different fund structures (e.g., traditional mutual fund to ETF, or vice versa). This is, in part, because of differences in the fund structures that could cause an investor to prefer one versus the other.⁵ The argument against a superficial loss would be even stronger where the underlying securities are not identical. Similarly, switching between different mutual funds or different ETFs with similar (but not identical) exposures would likely achieve the same result. To ensure the ability to claim a capital loss without two ETFs (where possible) being considered identical property, where possible, consider ETFs that follow different benchmarks. Again, we use the example of Cliff to illustrate our point:

Cliff purchased 3,000 shares of ABC Emerging Markets ETF on August 10 for $30,000 ($10 per share). Thinking about capital loss planning, on October 11, Cliff sold all shares of the fund for proceeds of $24,000 ($8 per share), resulting in a capital loss of $6,000. Wanting to continue to participate in the emerging markets, three days later, on October 14, Cliff bought 3,000 shares of XYZ Emerging Markets ETF at $9 per share and continued to hold these shares for the remainder of the year.

Since Cliff replaced one emerging markets ETF with another, he was able to maintain exposure to this particular market segment. And, because the two ETFs have similar but different underlying securities and follow different benchmarks, they are not considered identical for purposes of the superficial loss rule.

It’s also important to note that capital losses triggered by transferring securities (including ETFs) from the non-registered environment directly to an RRSP or TFSA (i.e., a registered environment) would be denied under a separate stop loss rule.⁶ To avoid falling under this rule, investors can trigger the loss by switching to a different security in the non-registered environment, followed by a cash contribution to the RRSP or TFSA. The investor should then wait at least 31 days from the time of the original sale before reacquiring the original security (but his time it’ll be purchased within the RRSP or TFSA). For more information on this topic, see CI GAM’s Tax, Retirement and Estate Planning paper, "In-kind transfers to registered plans: Dealing with superficial and denied loss rules".

¹ Assumes the investment is held on capital account. If the investment is held for business purposes, business income or losses would normally result.
² Section 54 of the federal Income Tax Act (ITA), definition “superficial loss”.
³ Interpretation bulletin #IT-387R2.
⁴ Technical interpretation inquiry #2001-0080385.
⁵ If engaging this strategy, check with the product issuer to ensure that the fund structures are different and not simply different purchase options of the same structure.
⁶ Section 40(2)(g)(iv) of the federal ITA.