No Tax Pain, No Capital Gain

On April 16, 2024, the Federal government announced that the capital gain inclusion rate is increasing as part of its annual budget. This is certainly one of the more significant tax changes Canadians have seen in recent years. While many business owners and other individuals expect to be unaffected, they may be surprised to see just how pervasive the tax pains caused by this capital gains proposal may be. For some, there may be planning opportunities to ease this pain.

A background on capital gains inclusion rates

Capital gains are currently subject to a 1/2 inclusion rate, meaning that only $50 out of every $100 of capital gains you realize are included in your income and then taxed at your marginal tax rate along with your salary and other income. The other 1/2 of the gain is received tax-free; this is the reason why capital gains have a reputation for being preferred over other forms of income. From a tax policy perspective, the inclusion rate is meant to reward taxpayers with a lower tax liability when they risk their capital by investing.

The inclusion rate hasn’t always been 1/2, but it has been 1/2 for quite some time now – almost 24 years. Some readers might remember the following inclusion rates from years prior:

The proposal included in Budget 2024 is to increase the capital gain inclusion rate to 2/3. This increased inclusion rate would apply to all capital gains realized by corporations and trusts as well as certain capital gains, net of capital losses, realized by individuals in excess of $250,000 in a taxation year. This new measure will be effective for capital gains realized on or after June 25, 2024, exactly ten weeks after the budget date. Presumably, this is the window of planning opportunity the government thought was appropriate for taxpayers to take advantage of a lower 1/2 inclusion rate one last time.

As shown in the table above, Canadians experienced a 2/3 capital gain inclusion rate twice in the past: in 1989 and 2000, with each of these being a brief layover on a path to a higher 3/4 or lower 1/2 inclusion rate. Hopefully, the increase to the inclusion rate in 2024 is not a foreshadowing of a 3/4 inclusion rate that is yet to come.

The impact of the proposals on individuals

The following table illustrates the effective tax rate on capital gains for an individual in the highest marginal tax bracket in Ontario where the 1/2 inclusion rate, the new 2/3 inclusion rate, and a hypothetical 3/4 inclusion rate applies:

These calculations tell us that capital gains subject to a 2/3 inclusion rate will have up to an additional 9% tax applied when compared to the 1/2 inclusion rate, but remember that this only applies to net capital gains – that is, the total capital gains minus capital losses applied, and excluding gains eligible for the capital gains exemption – on or after June 25, 2024, and only on the portion of that net amount that exceeds $250,000 in each year. Our calculations are for Ontario, but a similar result would be obtained for individuals resident in other provinces and territories.

Although most individuals expect to never have to report such a high amount of capital gains on their personal tax return, capital gains in excess of $250,000 are common when certain major life events occur, for example: the sale of a cottage, a rental property, or a business. Capital gains are also realized when an individual gifts real estate, shares, or other capital property, or dies while owning property, since these events are deemed to result in a sale at fair market value for income tax purposes. It’s not uncommon for someone who is normally in a lower tax bracket to have large capital gains in the year of their death. Individuals who cease to be resident in Canada are also subject to a similar deemed sale in the year of emigration, though this generally excludes real estate in Canada because it remains taxable by Canada upon an eventual sale. These major life (and death) events may now come with an additional 9% tax bill!

If a hypothetical 3/4 inclusion rate were to follow in the coming years, the increase in tax might exceed 13% in some cases. While we have no information to suggest the government plans a further increase to the inclusion rate, and a future government might even decrease it back to 1/2, individuals with large, unrealized capital gains might be interested to know the potential impact.

Capital gains realized by corporations

The table below illustrates the overall effective tax rate payable by the same individual resident in Ontario when earning capital gains in a Canadian-controlled private corporation, assuming the net sale proceeds are paid out to them as a dividend in the same year. The results would vary within a few percentage points in other provinces and territories but are otherwise similar:

As you can see, the same preferred tax treatment afforded to capital gains has generally been preserved when realizing them in a corporation, with only a 2.2% additional tax cost when compared to earning capital gains personally. This is due to the ability to pay a tax-free capital dividend to the individual shareholder equal to the 1/2 of the corporation’s capital gain that is tax-free. However, an important detail of the budget announcement is that the 2/3 inclusion rate will apply to every dollar of capital gains realized by a corporation – there is no $250,000 threshold. This means that the first $250,000 of capital gains in a corporation would result in an overall integrated tax rate of 38.62% in our example (under the 2/3 Inclusion column), compared to 26.77% if it was earned by an individual shareholder, representing an added tax cost of 11.85%!

Clearly, this is not an ideal result, and it suggests that you might be better off investing personally instead of in a corporation to access a lower 1/2 inclusion rate on a future capital gain up to $250,000. The result is even worse with a hypothetical 3/4 inclusion rate, with the effective tax rate of over 40% being similar to the effective tax rate on dividends.

Despite this, capital gains in a corporation may still be the better result as part of a lifelong, integrated, and optimized tax plan, because you would still consider whether the ability to defer tax and split income using a corporation outweighs the additional tax cost from realizing a capital gain in a corporation. There may be other benefits to a corporation, including limited liability protection.

Planning opportunities

Though things may seem a little grim at first glance, there may be a remedy for the tax pain in the right circumstances:

1. Crystallize gains before June 25, 2024 – To “crystallize” means to realize a capital gain on an asset now and lock in its current value with an increase in its cost base. In doing so, you purposely trigger a requirement to pay tax for 2024 knowing that this will avoid owing more tax on a capital gain with a 2/3 inclusion rate in the future. This generally makes the most sense when you plan on selling an asset soon anyway. The key to crystallizing a capital gain is to cause a disposition for tax purposes, which is not always straightforward. Some strategies might include selling an interest in property to a family member, corporation, or trust, or exchanging shares of a corporation in a way that avoids a tax-deferral. Special care must be taken if selling property to a spouse, since the default treatment would be a tax-deferred transfer (with no gain or increase in cost base) and an attribution of future income and capital gains back to you. An election out of this spousal rollover, in conjunction with a prescribed rate loan, might be a solution.

2. Optimize asset location – If your registered accounts are maxed out and you tend to invest both personally and in a corporation, then consider reallocating your investment holdings so that investments that tend to generate more capital gains are held in a personal non-registered account.

3. Leverage the corporate tax deferral – You may still generate more wealth if you reinvest your corporation’s profits in the corporation and defer the personal tax otherwise payable on a dividend to you. This is especially true if your corporation earns income from an active business, such as property development, building, construction, a profession (e.g., lawyers, doctors, dentists, etc.), farming, and many other businesses due to lower corporate tax rates on that active business income. Although future capital gains on your corporate investments would then be subject to a 2/3 inclusion rate, you are investing more money from the outset and the proceeds might be withdrawn and taxed at lower personal tax rates in your retirement years. The law could also change in a future year to reduce tax payable on capital gains of corporations.

4. Consider ways to split income and capital gains – The overall rate on a capital gain realized by a corporation or trust may be much less if you can split income with family members. Though income splitting has become more difficult with the introduction of the tax on split income (TOSI) rules in 2018, many strategies still exist depending on your family situation and the type of business you operate. A family trust may provide you with a flexile way to split income and capital gains with family members while retaining control over your properties or business. Capital gains retained by a trust would be subject to the new 2/3 inclusion rate, but if the proceeds of a capital gain are paid to beneficiaries in the same year and the trust’s tax filings are completed correctly, beneficiaries will be taxed on the capital gain instead of the trust and may each benefit from a 1/2 inclusion rate on up to $250,000 of capital gains.

5. Make living inheritances – Your wealth is potentially subject to punitive rates of taxation in the year you die, when your property is deemed to be disposed of at their fair market values if left to anyone other than a spouse. If you have significant wealth that is conservatively more than required to see you through your lifetime, consider providing advances on inheritances while you’re alive by gifting interests in property or businesses to your family now. This may be done along with an estate freeze to further limit your final tax liability and defer more tax for an entire generation.

6. Claim a capital gains reserve – If you sell property with a capital gain but receive proceeds over time, you may be able to claim a capital gains reserve to spread your capital gain over up to five years. This may be an effective strategy to remain below the $250,000 threshold where the 1/2 inclusion rate still applies, subject to two caveats: 1) you would normally prefer to be paid for a sale of property up front in order to eliminate creditor risk, and 2) as of the time this article was written, there is no draft legislation for the 2/3 inclusion rate, and so it remains to be seen whether this strategy would work.

7. Tax loss selling – Keeping accurate and timely records for your investments becomes ever more important with this new measure. Knowing the fair market value and adjusted cost base of your investments at all times will allow you to make informed decisions and potentially time the realization of capital losses to offset any capital gains that are subject to the 2/3 inclusion rate.

8. Stock options – The proposed measures will affect the exercise of stock options in a similar way. The budget documents were short on details in that regard, but if you hold options in a corporation that might entitle you a stock option deduction, take note and pay attention to any updates on this proposal.

Our final thoughts

The right planning will be highly dependent on your unique circumstances and goals. Before taking any action, you would want to consider implementation costs, including accounting fees, legal fees, and taxes, the loss of any tax deferral if you trigger a capital gain now, whether the alternative minimum tax (AMT) could apply, and the possibility that the tax laws surrounding capital gains change again, for better or worse.

If you are concerned about the proposed capital gain inclusion rate increase and how it affects your business and overall wealth, contact your trusted Gauvreau advisor for a consultation.

Disclaimer
The information in this document is current as of May 1, 2024, and is provided for informational purposes only. Tax law, its interpretation, and the administrative practices of the CRA and provincial taxation authorities are complex and are constantly changing. Some of the information contained in this document may be paraphrased and may be easy to misinterpret. Any suggested or implied tax consequences or planning opportunities may not apply in your circumstances or, if they do, may no longer apply or be appropriate at a future date. We recommend that you speak to us for professional advice regarding your specific circumstances before taking any action or refraining from taking any action based on your interpretation of this information. We accept no responsibility for any loss caused by reliance on the information in this document.