Taxing unrealized capital gains is not closing a ‘loophole’

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When should income be taxed? Put another way, especially in the context of business income, how is profit for tax purposes computed?

It seems like a straightforward question, but it’s not. It’s been the subject of a number of textbooks, numerous court cases and Canada Revenue Agency administrative positions. In Canadian tax, one of the landmark writings on this subject was Timing and Income Taxation: The Principles of Income Measurement for Tax Purposes, written in 1983 by eminent professor Brian Arnold. That paper was updated in 2015 by Arnold and a cast of superstar tax practitioners into a book, and both are staples for any serious Canadian tax practitioner.

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Why do I mention this? Well, for non-tax practitioners, it’s often taken for granted that you only pay tax when you receive something in exchange. For example, if you provide your labour and get cash in your bank account, you’re only taxed then. If you purchase a cottage property and then sell it for a profit, the realization date is when you need to report a taxable capital gain.

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However, our taxing statutes go much beyond those simple examples. For example, in computing business profits, most businesses (with the exception of farming and fishing) must record profits on an accrual basis, not on a cash basis. In other words, if you sell something but have still not been paid, you generally (with some exceptions) must record that sale in your income. Inventory and capital purchases are not an immediate deduction. The above-mentioned paper/book dives into a lot of detail with respect to these issues.

I try to distil the complex timing and profit computation issues when explaining them to people I mentor into a bite-sized concept as follows: if there has been an economic realization, then there will generally be taxation consequences.

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There are numerous exceptions to this overly simplistic concept, such as deemed realizations upon death or becoming a non-resident of Canada, imputed taxable income amounts when certain conditions are met (for example, if I receive a loan from a company that I’m related to, I’m deemed to have received an interest income inclusion), deemed realizations when the use of a property has changed from, say, a personal use property to an income purpose, and a host of other exceptions.

The United States’ tax system is vastly different. Notwithstanding, the basic issues of how to compute income are similar, but again, different.

With the above in mind, I couldn’t help but shake my head at the United States presidential candidate Kamala Harris‘ proposal, which she has adopted from President Joe Biden, to tax unrealized capital gains for people who are worth US$100 million or more. For such people, they would be required to annually pay a minimum tax of 25 per cent of their income and unrealized capital gains.

In other words, wealthy Americans would pay an annual tax — akin to a wealth tax — on their unrealized capital gains.

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Some progressive think tanks trumpet the ideology that by not taxing wealthy people’s unrealized capital gains, such people are taking advantage of this “loophole,” but I like to think about it another way. This simplistic view is nonsense and violates the good concepts of common sense, fairness and the basic timing issues of profit generally described above.

Ideas such as these are poor policies that unfairly target the wealthy. It’s been in vogue forever to “tax the rich” and “stick it to the wealthy” since they are taking advantage of loopholes (a vacuous phrase that describes nothing), but proper taxation and economic policy needs a more foundational underpinning.

In addition, like any form of wealth tax, the idea is rife with administrative complexities, such as how to value assets (especially non-financial assets like businesses, land, rental properties and other real estate). What would happen if, in a subsequent year, there are unrealized losses and taxes have previously been paid on those unrealized gains? Liquidity issues would be common since wealth is often tied up in assets that can not be easily liquidated.

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As one well-respected U.S. tax lawyer recently said, the scariest part of the proposal is that this could open “the door to a more generalized effort by the government to tax you on something that you still own? Right now, the proposal is only to use this wealth tax for the truly wealthy. Not just billionaires, but also anyone with at least US$100 million. Once we start down this path, could we some years from now face a tax like this for someone with US$20 million, US$10 million, even US$1 million (of assets)?”

Another American commentator put it bluntly by quoting another think tank: “Taxing unrealized capital gains contradicts the basic principles of fairness and property rights essential for a free and prosperous society. Taxation, if we’re going to have it on income, should be based on actual income earned, not on paper gains that may never materialize.”

One can’t help but think that if this proposal were to somehow pass into law in the U.S., the exodus of capital would be large and would contribute to economic chaos.

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Despite the complexities of tax law (including the timing of receiving income and computing profit), there is inherently some common sense involved in developing all tax and economic policies. The Harris proposal to tax unrealized capital gains lacks common sense.

Canadians should watch with interest how this proposal plays out. Any similar types of proposals in Canada, such as a home equity tax, should be roundly rejected.

Kim Moody, FCPA, FCA, TEP, is the founder of Moodys Tax/Moodys Private Client, a former chair of the Canadian Tax Foundation, former chair of the Society of Estate Practitioners (Canada) and has held many other leadership positions in the Canadian tax community. He can be reached at [email protected] and his LinkedIn profile is https://www.linkedin.com/in/kimgcmoody.

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