Forex Trading: Income or Capital Gain Tax in Canada?

I’ve always known that foreign exchange trading is treated as capital gain tax in Canada. But just to be sure before filing my taxes soon, I’ve decided to double check the facts from Canada Revenue Agency. As you know, the difference between income tax and capital gain tax is substantial. Income tax is taxed at your marginal tax rate. Whereas capital gain tax is a generous half of your marginal tax rate. That works out to a 10% to 20% difference.

Taxes in Canada is generally simple to do. The problem though, is sifting through the cacophony of information within the Canada Revenue Agency to find out the applicable rules. I’ve copy and pasted a couple of relevant excerpts from the 2010 CRA Income Tax Interpretation Bulletin for the record.

Basically, forex trading can be treated as either income or capital gain tax in Canada (surprise). According to IT-95R Foreign exchange gains and losses.

2. Where it can be determined that a gain or loss on foreign exchange arose as a direct consequence of the purchase or sale of goods abroad, or the rendering of services abroad, and such goods or services are used in the business operations of the taxpayer, such gain or loss is brought into income account. If, on the other hand, it can be determined that a gain or loss on foreign exchange arose as a direct consequence of the purchase or sale of capital assets, this gain or loss is either a capital gain or capital loss, as the case may be. Generally, the nature of a foreign exchange gain or loss is not affected by the length of time between the date the property is acquired (or disposed of) and the date upon which payment (or receipt) is effected.

As you can see, it is very vague. That’s why forex trading can be considered income or capital gain tax. It is up to you and your accountant to figure out which works for you.

A noteworthy point in the above excerpt is that the holding period is not taken into account. So there’s no 30-day rule like in the states whereby frequent trading would miss out the capital loss credit if they re-purchase the same asset within 30-day of disposal.

Update: Looks like I have misconstrued the above article with regard to capital loss. As Olga pointed out in the comments, Chapter 5 of T4037 defines Superficial Loss. In which if you repurchase your property (e.g. stock) within 30-days after a sale at a loss, then that initial loss cannot be deducted as a capital loss. More about the Superficial Loss rules in Canada can be found at WhereDoesAllMyMoneyGo.com.

Further down the page in IT-95R, we have the following bullet.

6. A taxpayer who has transactions in foreign currency or foreign currency futures that do not form part of business operations, or are merely the result of sundry dispositions of foreign currency by an individual, will be accorded by the Department the same treatment as that of a “speculator” in commodity futures see 7 and 8 or IT-346R. However, if such a taxpayer has special “Inside” information concerning foreign exchange, he will be required to report his gains and losses on income account.

IT-346R Commodity Futures and Certain Commodities explains the tax treatment of speculation in the commodity markets.

7. As a general rule, it is acceptable for speculators to report all their gains and losses from transactions in commodity futures or in commodities as capital gains and losses with the result that only one-half the gain is taxable, and one-half the loss is allowable subject to certain restrictions, (hereinafter called “capital treatment”) provided such reporting is followed consistently from year to year.

So there, we have it. Amateur forex traders, such as myself, can report our forex trading gain/loss as capital gains and losses. The reason being that forex trading isn’t part of my business operation because I have another primary source of income (e.g. salary from another job).

Another reason against stocking into a registered trading account this year

There’s another reason why I am so reluctant to put money into a TFSA trading account to invest in Canadian stocks. As you know, in a registered trading account, such as a RRSP self-directed trading account or a Questrade TFSA trading account (aff), you cannot short shares and can only buy because you can’t trade on margin. As such, a registered trading account is an account for buy-only trading.

It doesn’t take a genius to figure out that a buy-only trading strategy is best used … in a bull market. As trading wisdom goes, trade with the trend. So the question is, are we in a bull market in 2010?

Figures 1 and 2 shows the weekly chart of TSX Index and the TSX Venture Index, respectively.

Referring to Fig. 1, TSX is bumping up against some headwind at a 12,000 resistance. Unless TSX can stay above 12,000 cleanly (a weekly low above that level at least), I am still bearish in the market because that financial crisis back in 2008 (remember those days?) is still overshadowing long term prices and trader sentiments.

TSX, weekly

TSX Venture is depressed even more as seen in Figure 2 below. Just look at the huge gap from current price to the 200 week moving average (red line). This isn’t a good sign as lack of interest in high-risk stocks means traders are generally cautious.

Yes, it’s true that the equity market has been running up, up, and up for a good year. However, the fact that TSX is sitting at the same level as in 2001 proves that the long term, multi-year bull market has been cleanly broken.

We might very well see pockets of multi-month rallies materialize (like we’re seeing now), but unless proven otherwise, the long term trend is not looking green for the markets. It will not be easy money in the stock market like back in the pre-tech bubble 1990′s.

As opined by Bill Cara, the time for buy-and-hold is gone. It is well known in the community that the coming years will be volatile with big ups and downs. That is my little secret for moving to trade forex last year and the main reason why I am reluctant to set aside money on a one-sided stock trading account.

TSX Venture, weekly

Not pay trading income taxes through a TFSA trading account

RRSP contribution deadline on March 1st is fast approaching. Like most Canadians, this is pretty much the only time when I give myRegistered Retirement Savings Plan some attention. Right now, my RRSP balance stands at $0. That’s right, nothing. I’ve been putting my money at work for 10 years trading all sorts of markets but willfully ignoring the biggest cost to any trader. Taxes.

Now that my marginal tax rate is for the first time running above 30%, and with no tax break in sight, it’s time that I take a hard look at my tax strategies to reduce my trading costs. Don’t worry, this isn’t yet another post about RRSP. (But if you’re indeed looking for RRSP information, I point you to a Canadian personal finance blog, MillionDollarJourney)

The reason why I haven’t placed money into my RRSP is same as why I don’t invest in real estates. Which is, a lack of liquidity. As the name suggest, RRSP is for retirement. Here’s the problem simplistically put. If I take money out while I’m still working, I get taxed at my full marginal tax rate for those money. Even if they were supposed to be capital gain. Thus I effectively lose my 50% tax discount from my investment capital gain. So money into my RRSP would effectively be locked in while my salary is still my main source of income! I don’t have a wad of cash where I can just stash away yet. So that’s why my RRSP stands at $0 this year. Although I am thinking of opening an RRSP soon… But I digressed.

The fact is, taxes in Canada is ridiculously high. So I need to do something about it soon. While looking for RRSP information, I came across Questrade’s Tax Free Trading Account. It is a reincarnation of the Tax Free Savings Account. As far as I know, Questrade is the only discount broker offering this type of account. Basically, it is a trading account in which there is no income taxes involved and any profit taken out would not count towards annual income too. Sounds too good to be true?

Here are 3 limitations for a TFSA trading account.

1. Limit of $5,000 contribution per year
2. Extra costs for trading the U.S. markets
3. Cash account only, no margin.

I will discuss #2 shortly.

But #3 is what matters the most to me as a trader. No margin means no leverage, no shorting, and no futures and forex trading.

No shorting?! One-way trading is not a good thing for a trader. This is obviously a ploy to get people to buy, buy, buy.

And no forex trading?!

Yet, I can’t expect to have my cake and eat it too. Yes, this TFSA trading thing has strings attached. But. It’s tax-free!

That’s enough incentive for me to consider incorporating it into my portfolio. Make no mistake, this will not be my primary, or even secondary, trading account. My plan is to use it as an ultra-conservative investment vehicle only. It’s about time that I replace my abysmal 1% yield savings account!

Beforeopening a Questrade TFSA trading account (affliate link) though, I need to do my homework on Canadian stocks. Because TFSA is a Canadian government offer, trading U.S. markets would incur extra costs (a devious way of “Buy Canadian”). As such, the only cost effective way for me to maximize a TFSA trading account is to trade TSX and TSX Ventures stocks.

This is yet another item on my to-do list. Come up with a strategy to trade this account with minimal risks (can’t stress this enough)using Canadian stocks. I actually have some ideas already. But I’ll save that for another time.

In my next series of posts, I ask a fundamental investment question like any trader should. Is a $5000 Questrade TFSA trading account cost effective?

P.S. For more information on Questrade, youngandthrifty.ca offers a review of this discount broker.