Optimizing After-Tax Returns on Options

Although the options strategies presented in a previous article are very attractive, where you hold the investment is as important as the investment itself, the idea being to obtain the best after-tax return. Please note that the comments made in this article reflect the tax reality at the time of publication.

This options-focused article, the last installment of a four-part series, delves into strategies for optimizing return on investment when factoring in tax implications. In brief, Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs) offer superior flexibility for investors to hold options compared to their standard brokerage account.

How are options taxed?

Profits and losses from options are classified as either income or capital gains. Each classification comes with its own taxation laws. To determine how your options will be taxed, consider the following:

1. Income Account: Gains are fully taxable at a rate of 100% while losses are deducted against income from all sources.
2. Capital Account: Gains or losses on capital account are taxable at a reduced rate of 50%. However, they must be applied against other capital gains or losses.
3. Carry Forward: A gain or loss on an income account can be carried forward for up to twenty years or carried back for up to three years. By contrast, a gain or loss on a capital account can be carried forward indefinitely or carried back for three years.

How to determine whether a transaction affects capital or income

The Canada Revenue Agency (CRA) is responsible for establishing criteria that differentiate gains or losses on income accounts and those on capital accounts for option transactions. Here are the factors to consider:

Income Account: If you’re a trader or dealer in securities, make quick profits, engage in frequent transactions, hold securities for a short period, possess in-depth market knowledge, conduct transactions as part of your ordinary business, spend substantial time studying securities, use margins or financing, or advertise a willingness to buy securities, your transaction may be classified as income.

Capital Account: If the above criteria do not apply, an investor’s transaction will likely be considered on a capital account.

The CRA generally assumes that gains or losses from options trading are treated similarly to stock transactions. For detailed tax treatment for each type of transaction, please refer to the Equity Options Tax Regime guide available on the Montréal Exchange website, specifically pages 6 to 9.

Options and tax regimes

Options are eligible for your registered accounts. Please note that certain strategies are permitted, while others are not.

Securities listed on designated exchanges, like the Montréal Exchange, are generally eligible for RRSPs and TFSAs. However, any investment that could result in losses exceeding the cost of the security is not eligible.

Buying call options, buying put options, and covered calls are permissible. Equity options, currency options, and index options are all eligible for investment purposes in RRSPs and TFSAs.

The CRA has the authority to monitor transactions within registered plans, so investors may want to consult with a tax expert prior to placing their first trade.

Auditing and non-compliance with regulations

The following can trigger an audit:

1. Low employment income and significant Low employment income and significant capital gains income.
2. Frequent transactions: you will have to submit a T5008 form and a Relevé 3 to the government annually. This form will expose your purchases and sales.
3. Unique expertise or in-depth industry knowledge. For example, a broker who engages in frequent personal trading would be closely monitored. A bit like a real estate broker who flips properties.
4. Inconsistencies or previous audits: If you’ve already been the subject of a report to the CRA, the chances of a repeat offense increase.

The consequences of an error can be multiple. These mainly involve tax audits by the CRA, excess contribution rights, taxes to be paid on profits made and, ultimately, penalties.

Over-contributions. Remember that if you exceed the TFSA contribution limits, you’ll pay a penalty equal to 1% for each dollar over the limit per month. For the RRSP, the same rule applies, but you have a margin of $2,000 for life before being penalized.

Needless to say, you should consult a tax professional when filing your taxes if you frequently trade options.

Ensure to stay on top of any new information released by the CRA to stay up to date on how to report your options trades.

As the final installment of a four-part series, these articles were written to help lay the foundation for using options as part of your portfolio management. Consult the other articles you might have missed.

Article 1: Using options to express market views

Article 2: Protecting your portfolio through a volatile period

Article 3: Using the options Greeks to Enhance Hedging Strategies

This document is for information purposes only. Desjardins Securities assumes no responsibility for any errors or omissions and reserves the right to change or revise the contents at any time without notice.

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