Reporting Real Estate Character Conversions from Capital to Inventory

Last week, the Canadian Department of Finance released proposed technical amendments to the Income Tax Act to deal with perceived deficiencies related to the housing market. Buried within those (very short, by technical amendment standards) changes is a suspension of the limitation period for the Canada Revenue Agency (CRA) to reassess virtually any taxpayer who fails to report a real estate sale or other disposition where the real estate is held as capital property at the time of disposition.

By way of background, the main targets of last week’s amendments were principal residences –limiting foreigners in claiming the principal residence exemption, limiting the ability of trusts to designate a property as a principal residence, and requiring individuals who claim the principal residence exemption to report the sale in their tax return. Coupled with those changes was a requirement to report a sale or other disposition of real estate that is capital property, or else face an unlimited period within which the disposition could be audited and, if thought fit by the CRA, be reassessed. Thus, a standard twofold approach was adopted, consisting of reporting coupled with extended reassessing periods if a taxpayer fails to report.

If the purpose of the amendments was to enable claims for the principal residence exemption to be properly audited, one would expect the unlimited reassessment period to only have applied to individuals or trusts entitled to claim the principal residence exemption. That is, one must report the disposition (of the principal residence) or else face an unlimited reassessment period. However, the new reassessment rule is much broader than that.

For unexplained reasons, the new unlimited reassessment period also applies to taxpayers other than individuals and qualifying trusts, such as corporations, partnerships and non-qualifying trusts (except real estate investment trusts) that dispose of real estate capital property – and that would not be eligible to claim the principal residence exemption in the first place. Now, nearly all taxpayers who fail to report a disposition of capital real estate will face an unlimited reassessment period.

It is far from clear what this new rule is trying to capture by sweeping in other taxpayers such as corporations and partnerships. The Explanatory Notes released with the legislation do no more than paraphrase the legislation itself (an unfortunate trend with new tax legislation), while the accompanying Backgrounder states only that “an additional measure would improve compliance and administration of the tax system with respect to dispositions of real estate, including the sale of a principal residence.”

My view is that this aspect of the technical amendments represents a covert attempt by the Department of Finance to cope with the 2013 decision of the Federal Court of Appeal (FCA) in C.A.E. Inc. v. The Queen, as it applies to real estate. We have previously written about the C.A.E. decision here, and about the CRA’s dismissive reaction to the decision here and here.

Before C.A.E., the longstanding practice, in situations where a taxpayer converted a property from capital to inventory (but continued to own it), was to report the gain in the year of actual disposition as being partly on capital account and partly on account of income, with the property being valued at its fair market value at the time of conversion. This accepted practice was based in part upon the House of Lords’ decision in Sharkey v. Wernher, (1955) 36 TC 275.

In Sharkey v. Wernher, Lady Wernher owned both a stud farm (a taxable farming activity) and a stable of race horses (a non-taxable recreational activity). She transferred horses from her breeding operation to her racing operation and the question arose as to whether the transfer was a taxable disposition, and, if so, at what price the transfer occurred.

After overcoming the conceptual hurdle that a person can in law trade with herself, the House of Lords concluded that the proper transaction value on transfer of the breeding stock to the racing operations was fair market value.

The valuation principle in Sharkey v. Wernher was administratively (if not legally) adopted by the CRA in paragraph 8 of Interpretation Bulletin IT-102R2. There, the CRA says that where property is converted from capital to inventory, “the amount of any income gain or loss arising on actual disposition of the converted property will be determined in accordance with generally accepted accounting principles on the basis that its initial inventory value is its fair market value on the date of conversion.” The change-in-use rules in section 45 were viewed as not applying in circumstances where the property remained in an income-earning use, albeit inventory not capital.

When the C.A.E. decision was released, the FCA stated that the Act requires that the conversion from capital property to inventory (and vice versa) should be treated as a change in use, which under section 45 gives rise to a deemed disposition in the year of conversion notwithstanding that the taxpayer continues to own the property. While this approach gave the same value breakdown between capital gains and income as the CRA’s existing interpretation, the timing of the reporting was different. It moved the capital gains reporting from the year of actual disposition (under the CRA’s regime) to the year of conversion (which constituted a deemed disposition under the rule in C.A.E.).

Wholesale adoption of the C.A.E. decision could have led (and likely did) to situations where taxpayers reported contentious sales entirely as capital gains in the year of sale and, on challenge by the CRA, fell back upon an alternative argument to the effect that the sale was at least partly on capital account and partly on income account because of an earlier change of intention – and, by the way, the capital component of the gain was statute-barred as having occurred some years previous, based on the decision in C.A.E.

The CRA’s potential inability to reassess the gain arising in the earlier taxation year – “significant compliance and administrative burdens”, as it said at the time – were cited by the CRA as being one reason for it refusing to follow the C.A.E. decision.

Now, in those situations, the CRA will have the luxury of following the C.A.E. decision because it will have an unlimited time within which to reassess the deemed disposition arising on conversion.

For example, if a taxpayer argues that a property was converted from a capital use to inventory in a year preceding its actual sale, the CRA can now go back and reassess the earlier year for the tax arising on the gain at the time of conversion.

This change will not affect real estate reported as inventory on sale. However, it could affect taxpayers who report the ultimate sale of real estate as a capital gain but where that characterization is in doubt (for example, where a property was initially acquired as capital property but a conversion event, eg. rezoning or subdivision, resulted in a change to inventory). The failure to report the earlier (deemed) disposition will now leave that earlier year open to reassessment if the taxpayer argues the point upon being reassessed as inventory in the year of actual disposition and asserts that the gain is partly on capital account and partly on inventory account. It may still be worthwhile to make this argument; however, rather than the upside being a tax-free win on the capital element (if the earlier year was statute-barred), the upside will be the reduction from income rates to capital gains rates (ignoring additional interest costs on overdue taxes).

Now that the CRA no longer has to deal with the administrative and compliance burdens wrought by C.A.E., at least in the real estate context, it remains to be seen whether the CRA will finally concede that C.A.E. is correct in law.