Am I Earning Business Income or Investment Income?
The COVID-19 pandemic has created novel socioeconomic conditions where many Canadians are in a state of professional flux. The prospect of earning supplementary income is tantalizing, and retail investing has never been more accessible to the taxpayer.
The advent of smartphone trading apps and low- or no-fee trading has provided many Canadians with the opportunity to purchase and sell securities without the interposition and cost of an investment broker. However, there may be tax implications and/or reporting requirements depending on the type of earnings garnered though retail investing.
While many investors believe that sheltering their investments under a tax-free savings account (TFSA) is the solution to the inclusion dividends or capital gains earned from the purchasing and/or selling of securities in their taxable income for a given taxation year, TFSAs do not offer categorical protection from paying taxes on investment earnings.
It is critical to discern whether the earnings garnered from a retail investor’s securities are “business income” or “investment income” under the Income Tax Act. If the Canada Revenue Agency (CRA) determines that the investment earnings are “business income”, the taxpayer must include those earnings in the taxpayer’s taxable income for that taxation year (regardless of the account in which the investment is being held).
So how does one determine whether investment earnings are “investment income” or “business income” under the Income Tax Act?
Investment Income vs. Business Income
The distinction between “investment income” and “business income” stems from the motive of the taxpayer for purchasing the security. TFSAs are designed to protect “investment income” from taxation, so if a taxpayer is determined to be purchasing a financial instrument with the view of “investing” (as opposed to quickly profiting), this would be material in the CRA’s determination process to characterize the earnings as “investment income” versus “business income”. It is difficult to establish one’s motive for purchasing a security, so assessing this motive typically falls on viewing the activity of the taxpayer with respect to the security and the trading account in general.
The earnings garnered by retail investors could be characterized as business income where the trading undertaken resembles that of a “trader”. Essentially, where the level of trading activity engaged in by the retail investor during the course of the taxation year is analogous to what a trader would undertake, any earnings may be assessed by the CRA as “business income” and included in full in the taxpayer’s income, despite taking up valuable contribution room in the taxpayer’s TFSA.
What sort of activity would re-characterize what would otherwise be “investment income” as “business income”? If a retail investor is trading too frequently to the point where their activity could be labeled “day trading”, the CRA may assess earnings under the TFSA as business income. The exact number of transactions that would constitute “day trading” is not defined and is not the sole factor in determining whether earnings under a TFSA are “business income”. But frequent transactions that would lead a CRA agent to believe that the financial instruments were not purchased with a view to “invest” may be determinative in the CRA’s decision-making process.
The profession of the TFSA-holder would also be considered by the CRA. The CRA may assess what would otherwise be “investment income” as “business income” where the TFSA holder works in the financial sector or deals with securities regularly. This is because the motive of the retail investor may be coloured by his or her profession.
There is no definite method to protect oneself from having earnings under a TFSA (or other registered account) reassessed as “business income”. It is imperative to understand the eligibility requirements of financial instruments held under the TFSA and to be cautious with the type and number of transactions entered into as a TFSA-holder, as the assessment of earnings as business income could have significant tax consequences for the retail investor.
If you are concerned about unreported taxable income from your retail investing or wish to carefully plan your investment portfolio to ensure compliance with registered savings plan rules and eligibility requirements, contact a tax professional at R&A Tax Law today!
**Disclaimer
This article provides information of a general nature only. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in this article. If you have specific legal questions you should consult a lawyer.
James Pendergast