Capital Gains vs Business Income.

Capital gains versus business income.

Why is it important to understand the difference between income from capital gain and business??

Under current tax laws of Canada, only 66.67% of the capital gain realized by corporations and trusts is included in taxable income, known as “inclusion rate”, while business income is included 100%. For individuals, the inclusion rate of capital gain up to $250,000 is 50% in taxable income and any capital gain over $250,000 is included @ 66.67%. Therefore, business benefit from classifying income as capital gain, while the taxman (CRA) would like to classify it as business income. 

 For transactions before June 25, 2024, capital gain’s inclusion rate was only 50% for individuals, corporations and trusts. 

Capital gains are realized from the disposal of CAPITAL PROPERTY, while business income is generated from the sale of INVENTORY in the normal course of business.

What is capital property?

In simple words, capital property is acquired with the primary intention of holding or using it for business (like a factory or plant and machinery) and not for selling it for profit. On the other hand, inventory is acquired with the original intention of selling it (like raw-material, finished goods etc.).

In some cases, the distinction between the two incomes is clear, but not so obvious in many cases. Courts decision uses the analogy of a fruit tree. For the entity, whose business is selling fruit, the tree is a capital property because the entity does not intend to sell the tree, but the intention is to hold the tree and use it. So, if, for any reason, the entity decides to sell the tree (capital property), any gain will be classified as capital gain, and only 66.67% (only 50% for transactions before June 25, 2024) of the income will be taxed.

On the other hand, fruit on the tree is an inventory because it is sold in routine business to generate profit for the entity. Income generated from selling the fruit is a business income and will be fully (100%) taxed.

Generally, courts consider the following in determining whether an item is capital property or inventory: –

1. Primary intention
2. Secondary intention
3. The relationship of property with the taxpayer’s business
4. Type/nature of property
5. Number as well as frequency of similar transactions
6. Length of time for holding the asset.
7. Additional work done on the property to make it marketable.
8. Circumstance triggering disposal.

The decision is made by courts after taking into account all above factors.

If you have a question about the above or any other tax and accounting issue, please feel free to reach out to Source Accounting. If you find this post helpful, please let us know in your comments.

Disclaimer: The above contents are provided for general guidance only, based on information believed to be accurate and complete, but we cannot guarantee its accuracy or completeness. It does not provide legal advice nor can it or should it be relied upon. Please contact consult a qualified tax professional specific to your case.