Capital gains changes not very inclusive

One of the most noteworthy measures to come from Budget 2024 is the proposed change to the capital gains inclusion rate, which was previously held steady at 50% since 2001.

For individuals, capital gains in excess of $250,000 annually will be subject to an increased 66.67% inclusion rate as of June 25, 2024, while capital gains up to $250,000 will continue to be subject to the existing 50% inclusion rate. As a transitional measure for 2024, only the capital gains realized by individuals on or after the effective date of June 25 that are above the $250,000 threshold will be subject to the increased inclusion rate.

For trusts and corporations, the inclusion rate on all capital gains will increase from 50% to 66.67% starting on June 25, 2024.

Historical reference: Capital gains inclusion rate

Those of us who’ve been around long enough understand that this recent change was not the only time the capital gains inclusion rate has deviated from the 50% inclusion rate. Over the years, the capital gains tax rate has ranged from nil to as high as 75%, as indicated in the table below. In fact, prior to 1972, there was no tax on capital gains! 

Excluding the 2024 tax year, we have given a rough estimate on the percentage of time spent at each of the various capital gains inclusion rates over the last 42 years. As we can see, most of the time, the capital gains inclusion rate has remained at the 50% inclusion rate. For the last 23 consecutive years, the inclusion rate has remained untouched, with the last change being back in tax year 2000, with various changes introduced that year.

Impact to individuals

Budget 2024 proposed to add transitional rules that would specifically identify capital gains and losses realized before the effective date (Period 1) and those realized on or after the effective date (Period 2). The effective date is June 25, 2024. Capital gains realized on or after that date will have an inclusion rate of 50% on the amount up to $250,000 and an inclusion rate of 66.67% on the amount above $250,000. All capital gains realized prior to the effective date will have an inclusion rate of 50%.

Take Ontario as an example. The proposed higher inclusion rate on capital gains would effectively increase the effective federal-provincial tax rate on capital gains above $250,000 from 26.76% to 35.69% for Ontario residents in the top income bracket. A more detailed analysis of the impact of these changes on an individual’s tax rate is discussed below.

For net capital gains realized in Period 2, the annual $250,000 threshold would be fully available in 2024 (i.e., it would not be prorated) and it would apply only in respect of net capital gains realized in Period 2.

The $250,000 threshold would apply to capital gains realized by an individual, either directly or indirectly via a partnership or trust, net of any: Current year capital losses, capital losses of other years applied to reduce current year capital gains, and capital gains in respect of which the Lifetime Capital Gains Exemption, the proposed Employee Ownership Trust Exemption, or the proposed Canadian Entrepreneurs’ Incentive claimed.

Two common scenarios where individuals may exceed the $250,000 capital gain threshold are the deemed disposition of capital property at death and the deemed disposition of capital property on emigration from Canada (i.e., becoming a non-resident for income tax purposes). We have provided additional details on these topics below.

Deemed disposition upon death

When an individual passes away, they are deemed to have sold their capital property (e.g., units or shares of mutual funds, shares of corporations, and real property) at its fair market value (FMV) immediately before their death. If a capital gain arises as a result of this deemed disposition, that capital gain is reportable on the deceased’s final (terminal) tax return, and the taxes owing as a result, if any, would be payable by the estate of the deceased. However, there are provisions that allow taxes to be deferred when the property is transferred to a spouse. For example, if a capital property is transferred to a surviving spouse or common-law partner, subsection 70(6) of the Income Tax Act automatically deems the deceased to have disposed of that property, and the spouse or common-law partner immediately acquires the same property at the deceased transferor’s adjusted cost base (ACB). This is commonly referred to as the “spousal rollover.” Another possible strategy to plan ahead for potential large capital gains taxes at death is the purchase of life insurance since the death benefit is typically paid out tax-free.

Without careful planning, the estate value could be substantially reduced by the changes to the capital gains inclusion rate. Furthermore, it would be prudent to ensure there are liquid assets or cash available in the estate to cover the associated tax liabilities.

Non-resident departure tax

Residency in Canada for income tax purposes is a question of fact, which primarily depends on the individual’s residential and social ties in Canada. When an individual becomes a non-resident of Canada, they are deemed to have disposed of and immediately reacquired certain types of property at FMV. The tax incurred as a result of this deemed disposition and reacquisition is also known as the departure tax. Some examples of properties subject to departure tax include securities inside a non-registered investment portfolio, shares of Canadian private corporations, and real estate situated outside of Canada. Note that there are some properties that are exempted from the departure tax, including pensions and similar rights (including registered retirement savings plans (RRSPs), registered retirement income funds (RRIFs), tax-free savings accounts (TFSAs)), and Canadian real property.

The departure tax rules, coupled with the increased capital gain inclusion rate above the $250,000 threshold, may incur additional tax payable for emigrants. However, there is an option to defer the payment of departure tax on income associated with the deemed disposition upon emigration. By making an election, the individual would pay the tax later, without interest, when the property is disposed of. This election can be done by completing CRA Form T1244, “Election Under Subsection 220(4.5) of the Income Tax Act, to Defer the Payment of Tax on Income Relating to the Deemed Disposition of Property," on or before April 30 of the year following their departure from Canada.

Impact to entities

Corporations and trusts will also be impacted by the increased inclusion rate as of June 25, 2024. Unlike individuals, corporations and trusts will not have access to the old inclusion rate on the first $250,000 of capital gains; they will be subject to the new 66.67% inclusion rate from the very first dollar.

With the above in mind, there will be options available to shelter corporate and trust capital gains from the new inclusion rate.

For corporations:

The lifetime capital gains exemption (LCGE) can be used to eliminate capital gains taxes on the sale of qualified small business corporation shares (generally, these are shares of a Canadian-controlled private corporation that carries on an active business). The LCGE is also available for the sale of a qualified farm or fishing property. The current lifetime limit for the LCGE is $1,016,836. Budget 2024 proposed to increase that limit to $1,250,000 starting on June 25, 2024, so certain business owners will be able to reduce or eliminate their exposure to the new inclusion rate if they are able to make use of the increased LCGE limit.

For trusts:

Budget 2024 suggests that capital gains allocated by a trust to its beneficiaries on or after June 25, 2024, will be included in the beneficiaries’ income at the old 50% rate up to the beneficiaries’ first $250,000 of capital gains for the year. While the specifics are not yet available, this opportunity will likely create further planning considerations surrounding the allocation of capital gains from a trust to its beneficiaries to reduce taxes. Capital gains can generally be allocated to a beneficiary for tax purposes when they are actually paid to the beneficiary or when they are payable to a beneficiary (i.e., the beneficiary hasn’t received it yet but has a right to demand payment of the capital gain). The option of making income paid (or payable) to its beneficiaries and allocating such income to be taxed in their hands will largely depend on the trust terms.

Tax impact by province/territory

With the increase in the capital gains inclusion rate, we want to demonstrate the potential tax impact of those changes across jurisdictions in Canada. The table below shows the 2024 marginal tax rate for the highest individual income earners in each jurisdiction at both the 50% and 66.67% capital gains inclusion rate. The average difference is an increase in taxes payable of 8.45%. 

Next, we look at the additional taxes payable as a result of the inclusion increase at varying capital gains income levels. Of course, this assumes that the capital gains do not otherwise benefit from a reduced inclusion rate or an outright exemption, such as eligible in-kind donations of securities to registered charities or shares that qualify for the lifetime capital gains exemption, to name a few.

Understanding the tax implications of investing is an essential part of financial planning and reinforces the importance of working with a competent financial advisor to understand the long-term impact of these changes as they apply to personal situations. No doubt, tax rates influence capital allocation decisions. Canadians who take more inherent risk with their capital have traditionally been afforded preferred taxation rates promoting innovation through capital investment, something the government can do with good tax policy to encourage business growth and spur economic expansion. This is evident in the breakdown of the tax rates depending on the characterization of the income, as noted in the table below. 

The tax rates reflect the added capital risk investors and business owners take. We can clearly see the preferred taxation rates afforded to small business income and the general corporate tax rates on income over the small business limit, compared to the tax rate on interest income or employment income. That tax preference also extends to investors in “riskier” allocations of capital in marketable securities such as stocks, bonds, mutual funds, and exchange-traded funds, to name a few. The tax rates of less risky investments (such as money market instruments) do not benefit from the capital gains tax-preferred inclusion rates. With the latest move, there is not much difference between earning eligible dividend income from Canadian-resident corporations and realizing capital gains from dispositions.

Some pundits have declared the move as a disincentive to capital and business investment that may encourage businesses to move into more tax-favoured jurisdictions outside Canada. The Federal government has promoted the change as impacting a very small overall percentage of investors, estimated at 0.13% of Canadian individuals and 12.6% of corporations. Further, the Liberals have argued that the move is necessary to work towards “intergenerational fairness.”

Preparing for the changes

For now, advisors may want to start educating their clients about the basics of the changes, which starts with comparing the current inclusion rates with the new inclusion rates.

Individual investors with large unrealized capital gains will also likely ask if they should crystallize their capital gains before June 25 to save money on taxes in the long run. However, the assumption that selling now will result in overall savings will not be correct in all cases. There is an opportunity cost to pay taxes upfront rather than deferring those taxes to a later year. A cost-benefit analysis should be conducted in each case to determine whether it’s beneficial to trigger the accumulated capital gains before June 25, 2024.

For example, let’s assume an Ontario client owns a $2.5 million non-registered equity portfolio with $2 million in unrealized capital gains. They had no intention of selling those investments for another five years, but in light of the upcoming changes, they are considering selling immediately, paying the capital gains taxes now and then reinvesting the net amount after taxes back into those same investments for the five-year investment period. They are currently in the top marginal tax bracket in Ontario (53.53%) and expect to continue to be in five years’ time. The hypothetical average rate of return on their investments is 6% annually over the next five years.

As can be seen in this example, at a 6% annual compound growth rate, the option to realize much of the capital gains now resulted in a higher overall return in the amount of $61,992.66 over the five-year period due to the lower inclusion rate, as indicated in Scenario 1 compared to Scenario 2. If the investor does not crystallize the gains today, the equivalent rate of return needed to have the exact net after-tax amount at the end of the five-year period (the “breakeven return.” see below) would be a 6.60% compound annual return. While this certainly will not be true in all cases, this is the sort of analysis that will have to be conducted when assessing whether it makes sense to realize capital gains in 2024. The rate of return on investment and the investment horizon, among other things, are important determining factors.

For example, if we assume the investment horizon is fifteen years instead of five years, the analysis will draw an opposite conclusion, as illustrated below, as Scenario 4 results in a larger net after-tax return than in Scenario 3.

Breakeven rate of return and the breakeven time horizon

In fact, we crunched a few numbers to isolate the return needed in the scenario where all the capital gain is triggered in the future, with part of that gain taxed at the 50% inclusion rate and the rest at the higher proposed 66.67% rate. We compared that to the scenario of investing the after-tax proceeds following the crystallization of the current capital gain at a 50% tax rate and triggering a smaller amount of capital gain down the road. Though this is an academic exercise, we calculated the rate of return needed to be indifferent in either scenario and designated it as the “breakeven rate of return.” Given a specific investment horizon, if the actual rate of return is higher than the breakeven rate of return, the individual is better off not crystalizing the gain immediately because the higher return helps offset the tax impact of the higher inclusion rate beyond the $250,000 threshold.

Stated alternatively, assuming a constant annual rate of return in both scenarios, we calculated the timeframe required for the investment to recoup the additional tax due to the higher capital gains inclusion rate. We have designated this as the “breakeven time horizon.” When the actual investment horizon is longer than the breakeven time horizon, the individual is better off not triggering any gains immediately because the longer investment period generates sufficient return to neutralize the tax impact of the higher capital gain inclusion rate.

To conclude, these observations clearly reveal that the higher the rate of return, the longer the time horizon or holding period, and the lesser the impact of the increased taxes payable. Further, although we used securities investment in our example, a similar analysis can be done for other kinds of property held, such as a vacation property that is unlikely to benefit from the principal residence exemption. In addition, taxes often take a back seat to other planning considerations. These conversations should be had with the primary goals of the client in mind, which may supersede tax planning considerations.

For corporate investors, it is important to emphasize the impact the capital gains inclusion increase will have on small business owners. As a refresher, a corporation is a separate legal entity from the shareholders who own it and is subject to tax on the income it generates. Income is first taxed within the corporation before it can be passed to the shareholders in the form of dividends out of its retained earnings. To avoid double tax on income that passes through a corporation to shareholders (and to prevent any unintended tax advantages), a dividend gross-up and tax credit model is applied at the individual level, along with a tax refund mechanism to the corporation on passive investment income. This is designed to integrate the tax system between the two entities: Individual and corporation. Ideally, perfect integration is achieved when after-tax income is equal, whether it is earned individually or through a corporation. In reality, depending on the province and type of income earned, there could be a tax cost in earning passive investment income through a corporation, including earning passive investment capital gains income. Currently, there is, in fact, a tax cost for earning capital gains income through a corporation across all Canadian provinces/jurisdictions.

The latest change further increases the cost of earning passive investment income inside a corporation, though we do not yet know what changes will be made to the corporate tax refund mechanisms. As noted in the table below, the increase averages approximately 8.43% and nearly equates to the rate of eligible dividends. This rate reflects the initial tax rate on passive investment income earned within an active business.

For many small businesses, and perhaps to long-term individual investors as well, this increase in the tax rate will feel unfair as the accumulation of assets for retirement is often done within their small business corporation and, in many cases, the sole source of retirement savings.

If an immediate crystallization of accumulated capital gains is not desired, what should investors consider in the long run? Although many details of the new proposed rules are yet to be clarified, here are some general considerations.

For individuals, it may be helpful to plan the timing of future dispositions to stay below the annual $250,000 threshold. Also, it may seem obvious, but maximizing investments within registered plans, including the new first home savings plan (FHSA) where eligible, can reduce exposure to future capital gains tax. Moreover, estate planning becomes even more important as the potential tax payable on the deemed disposition of capital property at death rises. On that front, strategies to reduce capital gains at death could be considered, such as inter vivos gifting, charitable donation, spousal rollover, and acquiring life insurance to provide sufficient liquidity to the estate.

For business owners, some strategies to limit exposure to capital gains may include contributing to an individual pension plan (IPP), conducting an estate freeze to pass on future capital gains to succession owners, and ensuring the small business shares qualify for the LCGE. The most suitable strategies in any given situation are highly dependent on the business needs and personal situation of the business owner. 

Beware the superficial loss rule

Canada’s tax rules require an individual to wait at least 30 days before repurchasing the same property if they want to be able to claim the full amount of the capital loss. This is known as the superficial loss rule. Essentially, if an individual or their spouse/common-law partner purchases property identical to that sold within the period that begins 30 days before and ends 30 days after the disposition and still holds it on the 31st day after the disposition, then the loss on the original sale will be superficial. A superficial loss is deemed to be nil and cannot be claimed. Instead, the denied loss is added to the adjusted cost base of the acquired property.

The superficial loss rule also applies if the property is acquired by a company controlled by the individual or their spouse/common-law partner during the period outlined above. Finally, the superficial loss rule applies to trusts on which the individual or their spouse/common-law partner is a majority interest beneficiary. As a result, the strategy of selling property held in a non-registered account and reacquiring the property inside a Registered Retirement Savings Plan (RRSP), Registered Retirement Income Fund (RRIF), Registered Education Savings Plan (RESP), or Tax-free Savings Account (TFSA) is not viable.

If considering a crystallization of property in an effort to lock in unrealized gains at the 50% inclusion rate prior to the June 25 effective date, please beware of the potential application of the superficial loss rule to any property that is currently in a loss position. Note, however, that there is no such thing as a “superficial gain:” A crystallization of unrealized capital gains would simply result in those gains being taxable in the tax year of the crystallization. Where a transaction’s trade date and settlement date differ, such as a disposition of mutual funds, the disposition is deemed to have occurred on the settlement date, not the trade date.

In addition to the superficial loss rules, here are some other considerations.

In-kind transfers to registered plans: Often, investors fund their registered plans via an in-kind transfer of securities from their non-registered account. In-kind transfers from a non-registered account to a registered plan (e.g., RRSP or TFSA) will result in a disposition for tax purposes. Any capital gains triggered as a result of the disposition is taxable. A capital loss triggered from the in-kind transfer will be denied and unusable under Canada’s “deemed to be nil” rules. It is, therefore, more advantageous to realize the capital loss on the security within the non-registered environment first and then transfer the proceeds into the registered plan.

Transfer from trust to a corporate version of same mutual fund: Mutual funds and exchange-traded funds (ETFs) can be set up legally as trusts or corporations. Many corporate funds have different classes of shares. Each class represents a different portfolio of securities with a different investment mandate (e.g., technology, Europe, etc.). If you have an accrued loss on the trust version of a particular mutual fund, you could switch to the corporate version of that fund and crystallize the loss. A switch either way between the trust and the corporate class is considered a taxable disposition. When the other version of the fund is purchased, there is no superficial loss. This is because a different legal structure is being bought back, and not an identical property. Note, however, that a transfer between different classes of shares within the same mutual fund corporation will likely be caught under the superficial loss rules. The reason is that shares of the same mutual fund corporation are considered identical property to each other.

Purchase another fund in the same category: As an alternative to switching from a mutual fund trust to a mutual fund corporation, it may also be possible to realize a loss by switching from one mutual fund trust to another mutual fund trust in the same category. For example, it may be possible to realize the loss incurred from one Canadian equity fund trust by switching to another Canadian equity fund trust within the same family. The ability to claim the loss in this case will hinge on whether the two Canadian equity fund trusts are considered to be “identical.”

Similarly, the same could be said for ETFs. The Canada Revenue Agency (CRA) has stated that the determination of "identical" investments is a question of fact. Several factors are taken into consideration, including the legal structure of the investment entity, the composition of assets, risk factors, investor rights, and any applicable restrictions. Properties are generally considered identical where they are the same in all material respects, and an individual would not have a preference for one over the other.

Acting too soon or not fast enough?

Finally, there is what many in the industry have been calling a “change of law” risk. That is, within the next year and a half, a federal election is scheduled, and this capital gains inclusion tax policy will surely be something the Conservatives could choose as a primary election issue. As part of that election platform, they may promise to repeal it outright or alter its scope and application. Also, consider that any future changes to the capital gains inclusion rate could be retroactive or on a go-forward basis only; they could be far-reaching or apply only to limited circumstances. In short, even if the taxation of capital gains is changed once again after the election, it could take many possible forms.