Tax Loopholes: Devious Dealings or Dumb Drafting?

By Patrick Westaway

Original published on LinkedIn

This week’s announcement that Ottawa is closing a loophole which allows non-residents of Canada to claim the principal residence exemption must have the country scratching its collective head. Surely if people who have never lived in Canada qualify for an exemption intended for Canadian residents then black is white, up is down and the whole sorry tax system is done for. Hopefully so. But does the problem lie with a devious cabal of tax professionals or elsewhere?

Not enough is said about the fact that tax laws are too complex to be understood other than by a small minority of lawyers and accountants. Given the most basic of legal tenets that a law must be knowable, anyone without access to those few lawyers and accountants must surely be tax exempt: imagine living in a country where the criminal laws were so little understood and were, as tax laws are, imposed retroactively. So let us look at the “loophole” cited on Monday by our Finance Minister, the Honourable Bill Morneau.

As written by the Minister’s own department, property can be designated as a principal residence if it is “ordinarily inhabited” in the year. So what does “ordinarily inhabited” mean? How many days in the year constitute ordinary habitation? The legislation is silent on this point and the choice of wording intentionally vague. Referring to an Income Tax Folio published by the Canada Revenue Agency, one is told that the answer depends on the facts. Only from a tax specialist is one likely to learn that property will usually be considered to be “ordinarily inhabited” no matter how short the habitation so long as the property does not generate rental income.

Having reasonable grounds for believing that the property qualifies for the principal residence exemption, what of the taxpayer? Must one be a Canadian resident to claim the principal residence exemption? On a casual reading, the answer to this question is ‘yes’ since the years for which the deduction is available are described (within factor ‘B’ of a mathematical formula) as “one plus the number of taxation years that end after the acquisition date for which the property was the taxpayer’s principal residence and during which the taxpayer was resident in Canada”. Upon a closer reading, however, it appears that the Canadian residence requirement qualifies only “the number of taxation years that end after the acquisition date”, leaving non-residents with the benefit of the “one plus”. If, now, the Department of Finance says this reading does not reflect the legislative intent, why is the residence requirement buried within a formula? If the exemption is intended only for Canadian residents, the drafting alternative is simple and obvious.

As a result of this wording, non-residents have been entitled to deduct from their taxable income that portion of the capital gain that “one” is of the total number of years in which the non-resident owned the property. If the non-resident bought and sold the property in the same year then the full amount of the gain was exempt. If the non-resident held the property for ten years then only one-tenth of the gain was exempt. In the case, then, of a 10% gain on a Toronto condo purchased for $2,500,000.00 the year before it was sold, the principal residence designation was worth approximately $33,000.00—assuming combined Federal and Ontario top marginal rates. More commonly, a 15% gain on a Toronto condo purchased while under construction for $800,000.00 and re-sold post completion within the year for a 15% gain is worth slightly less than $32,000.00.

If the Department of Finance remains true to form, the revisions announced this week will serve only to further complicate the provision in question. Thankfully, we will have the text of this week’s announcement with which to interpret those revisions.