The Proposed Capital Gains Increase - What You Need to Know
Canadians can easily stay updated on the status of capital gains inclusion proposals with the extensive, almost daily, news coverage. As a taxpayer, you may be wondering if you should trigger gains before the rates change at the end of June. We suggest taxpayers wait until legislation is released before taking any action and, in this post, we explain why and provide a bit of history and factors to consider. We expect draft rules any day and will update this blog as soon as there are more details on the proposals.
Background on the Capital Gains Tax in Canada and Current Proposal
Capital gains in Canada were initially exempt from tax as the word “income” in the 1917 Canadian Income Tax Act was not broad enough to include gains. Over the years, the difference in tax treatment between income and gains gave rise to significant efforts of taxpayers to implement techniques designed to extract funds from corporations in the form of exempt capital gains rather than taxable dividends. This has been cited as the impetus of the Royal Commission on Taxation (referred to as the Carter Commission) and the start of the long-standing debate on the percentage of capital gains that should be subject to taxation in Canada with its report released in 1966. The Carter Commission tax reform recommendations included full taxation of capital gains and full integration of tax burdens borne by corporations and their shareholders. After almost 10 years of debate, the government finally introduced rules, effective in 1972, that subjected one-half of capital gains to tax and only partial integration.
The inclusion rate on capital gains has remained consistent except for the period between 1987 to 2000, when the inclusion rate increased to two-thirds, three-quarters, and then back to its current level of one-half. The 2000 Budget brief decreased the rates to give businesses better access to capital at a time of Budget surpluses.
The 2024 Budget proposes to increase the inclusion rate of capital gains again from one-half to two-thirds for corporations, trusts, and individuals on gains in excess of $250,000. These new rates are proposed to come into effect for gains realized after June 25, 2024. This again has spurred the long-standing debate.
Tax Impact and What You Need to Do
While many of us hope that lobbying efforts will push the government to stand down, the magnitude of revenue projections make this an unlikely outcome. We are expecting draft legislation any day and we encourage clients to continue a “wait and see” approach until then. Even when we see the new rules, we encourage taxpayers to take time to consider whether triggering the gain will save tax or cost them more in the long run.
We would like to see the government adopt the recommendations of various stakeholders and include a simple election with the new rules that will allow taxpayers to choose the gain to trigger in a careful and thoughtful manner. The best scenario is to file this with the 2024 tax return due April 2025. Forcing taxpayers to undertake significant cost in professional fees to execute a transaction in the span of three or four weeks is just not fair.
Election or not, taxpayers will need to make a choice: pay now or pay more later. If enacted, 16 2/3% more of each capital gain of corporations, trusts, and individuals in excess of the $250,000 limit will be subject to tax after June 25, 2024. The illustration below shows the net tax impact on capital gains personally and indirectly through corporations before and after the rules.
Whether to trigger a gain before the new rules apply is a question of time value of money. Specifically, what is the cost of paying tax now compared to paying more tax in the future. Using a simple example, it may seem the break-even point is around 4 years. Consider a situation where a taxpayer would need to sell an investment yielding 6% a year to pay the tax on any triggered gain in 2024 before the rate change. If the taxpayer is likely to hold the property for which the gain is triggered for more than 4 years then the taxpayer is better off keeping the investment and not triggering the gain. For properties that a taxpayer intends to sell in less than 4 years, there is an advantage to trigger a gain before June 25. Therefore, taxpayers should carefully consider their own unique situation and the need to fund the tax liability before undertaking any action to trigger the gain.
If no election is introduced with the proposed rules, then taxpayers will have to consider options to trigger the gain. A few include:
Sale and buy back the asset. This is a simple solution well suited for the sale of publicly traded shares, as an example, easy to sell and buy back.
For shares of a private corporation, such corporation should undertake a reorganization of capital allowing each of its shareholders to exchange their shares held for another class of shares having substantially the same share terms. This would allow the shareholder to do nothing (no gain) or file an election, if desired, to choose the amount of desired gain to be triggered. We are advising this approach on a number of divestiture transactions that are in process of being executed with target closing dates after June 25, 2024.
Transfer assets to another corporation or partnership and file an election to trigger the desired amount of gain. This election is due at the earlier due date of the tax return of the transferor or transferee but can be filed up to three years late provided the late filing penalty is paid. This would provide additional time for a taxpayer to consider the desired elected amount but could give rise to tax interest and penalties for any change in elected amount in the 2024 return made after filing.
Next Steps
As soon as the new rules are announced, we will provide updates. Our team is here to help you consider the options available to you. If you have any questions or concerns, please reach out directly to a member of the digitaltaxCPA team.
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