Written by: Steve Farnham
“The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.” – Jean-Baptiste Colbert, 17th Century French finance Minister
The proposed new rules around the taxation of capital gains
The proposed changes to the taxation of capital gains are a folly that will discourage risk taking and entrepreneurship and encourage mobile capital to depart from Canada. Like most of the tax changes that have been proposed/enacted/reversed over the past 5 years, the changes with respect to capital gains have been poorly thought out in terms of the impact and details of implementation.
There is no draft legislation or technical guidance, and all we have to go on to make potentially enormous financial decisions in a ridiculously tight window are a few paragraphs of explanatory material in the budget document.
The level of cynicism in our current government is such that the Budget actually anticipates billions of dollars of tax will be prepaid as a result of taxpayers scrambling to trigger gains prior to their arbitrary June 25 deadline. What if all of this tax is prepaid and the provisions are not implemented? While the NDP has announced that they will support the Budget, there is still a very lengthy process to actually pass the legislation, let alone write it. Unbelievably, there are still significant elements of the 2022 and 2023 Federal Budgets that have not been passed into law. If this proposal is not passed in 18 months, before the next election, all bets are off.
Having practiced and provided income tax advice for almost forty years, I have never seen the level of chaos and ineptitude at Finance as in the past seven years, beginning with the fated proposals announced by Bill Morneau in the summer of 2017. To quote my partner in her recent blog, these guys are off their rockers.
Nevertheless, we are where we are and the following blog is an attempt to provide some general, but practical guidance based on circumstances shared by many of our clients.
Background
The 2024 Canadian Federal Budget delivered in the House of Commons on April 16 proposes to increase the capital gain inclusion rate from one-half ( 50% ) to two thirds ( 66.67% ) for corporations and Trusts, and for individuals to the extent that capital gains realized in the year exceed $250,000. For individuals, the first $250,000 of annual capital gains will continue to be taxed at the 50% inclusion rate. The proposed measures apply to dispositions that occur on or after June 25, 2024.
While of no comfort whatsoever, we have been here before. The table below sets out the history of taxation of capital gains in Canada since the heady days when capital gains were not taxed at all:
To 1972 Nil
1972-1987 ½
1988-1989 2/3 Conservative
1990 – 1999 ¾ Conservative
2000 – 2024 ½ Liberal
2024 2/3 Liberal
It may or may not be instructive, for those hoping a change in government will return us to the days of wine and roses, that for the 11 years out of the past 52 where the capital gain inclusion rate exceeded 50%, the Conservatives were in power.
What does this change mean in terms of actual tax rates? Presently, for an Ontario resident individual in the highest tax bracket ( taxable income of roughly $250,000 ), the effective tax rate on a capital gain is 26.75%. For dispositions after June 24 the tax rate on gains over the $250,000 threshold will be 35.67%, or just under 9% higher.
If you are the owner of a private corporation and realize a capital gain inside the corporation, the results are even worse. Under the current rules, by the time the after tax corporate gain is distributed to the individual shareholder, the total effective tax rate is 28.96%. Under the proposed change, the rate will be 38.62%, an increase of almost 10%.
This is actually the best case scenario. Because a corporation does not benefit from the $250,000 threshold available to individuals, the appropriate comparison is between the individual rate of 26.75% on the first $250,000 of capital gains and the after tax corporate rate of 38.62%. This is a massive penalty of almost $30,000, simply because the individual realized the $250,000 gain in the corporation rather than personally.
As an added nugget of context, in the summer of 2023 the government announced significant changes to the Alternative Minimum Tax rules that came into effect on January 1, 2024. For individuals with taxable income above the new AMT threshold of $173,000, the effective federal tax rate on capital gains increased to 20.5% from 16.5%. Post June 24th, the federal tax rate on capital gains will be 22%, not significantly higher than the new AMT rate. While AMT is a refundable tax, in cases where there is a very large capital gain, for example with the sale of a business, it is unlikely the individual will be able to fully recover the AMT. In other words, for some, the new AMT rules alone brought the effective tax rate on capital gains to within a few percentage points of the tax payable under the new inclusion rate. This “back-door” increase in effective tax rates went largely without fanfare.
What now?
This change has a widespread and significant impact. According to the budget document only 0.13% percent, or roughly 40,000 individuals – in all of Canada ! – will be affected. That is nonsense. For a start, everyone who dies and has accumulated gains exceeding $250,000 will pay more tax. If you own a rental property or a cottage, you will pay more tax. If you have an investment holding company you will pay more tax. If you leave the country you will pay more tax.
There is obviously a great deal of concern regarding this change and the unprecedently short time frame in which to implement planning. While each individual circumstance is unique, my intention with this blog is to address the common questions we are receiving from our clients and to provide some general, but practical guidance.
Planning considerations can be divided into planning before June 24 and planning for after June 24. Obviously, the immediate concern is what to do, if anything, in the next seven weeks.
What to consider before June 25
Planning before June 25 effectively boils down to whether to prepay tax at the existing rate or to wait and pay tax later at the higher rate. Prepaying tax today at the existing rate means either actually selling something before June 25 that you would otherwise not be selling before that date or crystallizing existing inherent gains without actually selling the asset.
In terms of deciding to actually sell an asset prior to June 25, the decision hinges on when you would otherwise be disposing of the asset. If the answer is probably before the end of the year in any event, it makes sense to do your best to sell it before June 25. For example, if you are holding vested stock options and had planned on exercising sometime in 2024, do it before June 25 to ensure you get the 50% stock option deduction. If you have a rental property with terrible tenants and have been waffling on whether or not to sell, you may pay a lot more tax if you wait.
The decision becomes more complicated for assets that you had not intended to sell in the short term or when timing is uncertain. In that case you need to consider and balance the present value of the future tax cost against the tax prepayment today.
Assume you have an asset, say a share of a public company, with a $500 unrealized gain. You were not intending to sell it, in fact you still like the investment prospects. However, you do not want to be penalized by the new tax rates. If you sell it before June 25, the tax will be $133.75. You could then immediately repurchase the share. If you sell the share on or after June 25, the tax would be $178.33, an increase of $44.58! Sounds like a no brainer. However, you have now prepaid $133.75 in tax, and you would not have paid the higher amount of tax until some date in the future. If you do not sell now, but instead invest the $133.75 in say a GIC paying 5%, how long would it take to make up the difference? The answer is about 6 years. In other words, it would take just under 6 years to earn $44.58 in interest, the amount required to make up the tax difference.
Unfortunately, it is actually even more complicated than that, because if you did invest in a GIC and earned interest, there would be tax payable on that interest and so to earn the extra $44.58 after-tax, it would take something like12 years. But what if, instead, you invest the $133.75 in a blue chip stock that pays dividends and also appreciates – how long would it take then? Difficult to say, right? Starting to get the picture?
My own view, in terms of portfolio securities, unless you are Warren Buffet and hold forever, is that there are probably opportunities to improve the tax result by selling positions earlier than you might otherwise. This is a discussion to have with your advisor. There is also the issue of actually having the funds to pay the tax assuming you intend to repurchase the same position. Note that unlike with losses, there is no requirement to wait 30 days to repurchase a share sold at a gain.
In many cases there is not a desire to actually part with the asset or to repurchase it. This applies to real estate – cottages and rental properties – and to shares of private companies. Often this is where the largest exposure to the increase in rates lies. What are the options in this circumstance?
There are strategies available to crystallize the gain without giving up beneficial ownership of the asset. For example, the family cottage could be transferred to a Trust. This results in a disposition for tax purposes, but if done before June 25, the tax would be at the existing rate. There are similar strategies for corporate shares and corporate assets. However, with any of these strategies you are writing a cheque, and possibly a large cheque, earlier than you need to. The decision then is based on the same analysis as described above in terms of the time value of money. There is also always the nagging thought, perhaps more so the larger the cheque, that the rates will someday go back to 50% and the prepayment was for naught.
As two extreme examples: a couple in their 40’s with young kids and a cottage with an accrued gain of say $500,000 and a hope to hold the cottage for their kids, would likely not volunteer to prepay $133,750 – money that could be invested instead for perhaps decades. On the other extreme, grandma, who is 99, owns a cottage on Lake Muskoka, built by her late husband in the 1940’s, with a $5M inherent gain. When grandma passes away, she will be deemed to sell the cottage for fair market value. If that occurs after June 24, the tax will be $1,783,333. If, instead, the cottage was transferred to a family Trust before June 25, the tax would be $1,337,500, a savings of almost $450K. There is still an issue of how to fund the tax, but that exists in either case.
We have a number of clients considering selling their companies or in active negotiations to do so. This process typically takes months, if not longer, particularly if still at the stage of looking for a suitable buyer. Clearly, for these clients, there is no possibility of closing a sale before June 25.
In those circumstances, we can employ a strategy to benefit from the existing tax rates, without the requirement to write a tax cheque, but only for a limited period of time, typically one to three years. This strategy extends the opportunity to benefit from current rates, but only makes sense if a sale is anticipated. If the corporation is not ultimately sold, the shareholder can then decide whether or not to write the cheque to prepay the tax, although in the context of private company shares, the magnitude of the amounts coupled with uncertainty about the future selling price likely make crystallizing the gain unattractive.
What to consider after June 25
After this magical, totally arbitrary date, which should have been December 31, the planning is primarily on the individual side in terms of limiting gains to the $250,000 annual limit.
One strategy is to avoid carrying back any realized capital losses to 2023 and earlier years but instead preserving them to carry forward to help manage and limit net reported capital gains.
It goes without saying that, while the tax tail should not wag the investment dog, more attention will need to be paid to the timing of security dispositions giving rise to capital gains. For example, if you already have $250,000 in gains by the end of say November, consider deferring any additional dispositions until January of the following year.
Other related issues/comments
- The new AMT rules for individuals need to be considered in triggering any large gains in 2024.
- For those attempting to accelerate real estate sales to close by June 24, you can consider lowering the price or offering attractive payment terms and still be better off than closing after June 24 and paying the higher rate of tax.
- Remember for sales of securities, the trade has to settle on or before June 24 and it takes two days after the sell order for the trade to settle.
- Another significant factor in terms of capital gains arising in a corporation is the fact that the capital dividend account will be increased by only 1/3 of gains realized after June 24 instead of the present 50%. Under the current rates, if a corporation realizes a capital gain of $100.00, the shareholder can extract $50.00 as a tax free capital dividend. After June 24, this will be reduced to $33.33.
- It is not clear whether reserves on gains realized prior to June 24, but reported after June 24 will be subject to tax at the higher rate but it would appear so, notwithstanding the original gain was realized at current rates.
Takeaway
This is one of the most significant, far reaching, tax changes in many years. There is a very small window to determine if planning measures will be beneficial in individual circumstances.
We are here to assist with your questions and the implementation of appropriate planning.