Planning for Changes to Taxation of Capital Gains

The federal government has given Canadians 70 days’ notice to put their capital gains planning affairs in order. The 2024 federal budget’s surprise change to the capital gains inclusion rate from 50 per cent (1/2) to 66.67 per cent (2/3) will undoubtedly affect corporations and trusts. Only certain individuals will be affected by the proposed changes. We expect the proposals will be passed into law with the support of the NDP. The changes to the capital gains rates are proposed to be effective starting June 25, 2024.

IMPORTANT: Canada uses settlement date as the cut-off date for tax reporting, so a taxpayer must initiate a securities trade on or before June 21, 2024 to be settled before June 25, 2024 (T+1).

Stock option taxable benefits do not create capital gains but receive capital gains-like treatment due to the 50 per cent stock option benefit deduction against stock option employment income. The budget also proposes to change the stock option deduction to 1/3 to effectively increase the taxation of stock option benefits to 2/3 (66.67%) for benefits in excess of a combined limit of $250,000 for both employee stock options and capital gains.

Individuals

Complexity. The proposals introduce further complexity into Canada’s tax system by adding a new tier of individual capital gains taxation for capital gains net of capital losses greater than $250,000. For the 2024 tax year, capital gains and losses will have to be divided into two periods for the June 25th cut-off. Then the June 25th and subsequent gains and losses will be bifurcated into gains that are under the cumulative $250,000 threshold and gains that are over the $250,000 threshold. Current year capital losses and claimed capital losses carried forward are first applied against capital gains to determine the amount that exceeds the $250,000 threshold. Note the $250,000 threshold is not prorated for the June 25 to December 31, 2024 period.

EXAMPLE:

Timing is everything. Given the tight timeline to implement planning, individual taxpayers should review their taxable investment portfolios to determine if their current unrealized gains would be difficult to manage below the $250,000 threshold every tax year until death. Individuals with accrued gains in the millions should consider selling their highest gain assets before June 20, 2024 and repurchasing (if desired) to crystallize the gain at the lower 50 per cent inclusion rate. This is especially important if investors were already intending to rebalance a large portfolio or planning to trigger some market gains anyway. Keep in mind that securities in U.S. dollars likely also have inflated values due to the weakness of the Canadian dollar at the time of writing.

Individuals planning to sell real estate that is not eligible for the full principal residence exemption should also consider closing the sale before June 25, 2024 to avoid the higher inclusion rate. Non-resident individuals who own Canadian real estate should also consider that they will be affected by higher capital gains taxes upon sale of their properties.

Individuals should measure the long-term value of the possibility of deferred taxation at higher rates against the actuality of accelerated taxation at lower rates. A financial planner working in conjunction with your financial advisor and tax accountant can assist you with this decision process.

Investors should consider they may not have control over the date capital gains are realized, especially for investments that flow out capital gains such as mutual funds, ETFs, and partnerships. A corporate action such as a merger or takeover may also trigger an involuntary gain that the investor did not plan. Capital loss planning closer to the end of the year will become more significant when taxpayers are close to the $250,000 threshold.

Death and taxes. The federal government thinks that the proposed change will only affect 40,000 Canadians. However, most affluent investors will likely realize greater than $250,000 capital gains at death due to the deemed disposition rules. Note that the $250,000 threshold is not indexed to inflation in the proposals! The new rule is a clever way to prevent individuals from deferring large unrealized gains until the year of death.

It is important to monitor and manage capital gains throughout your lifetime to prevent a build up of gains that would be subject to higher tax rates at death. Seniors and other individuals who have a shortened life expectancy should consider crystallizing gains before June 20, 2024 to lock-in the 50 per cent inclusion rate to plan for capital gains to fall below the $250,000 threshold in the year of death. Also consider that couples may be able to split their capital gains now to stay below the threshold, but when one spouse passes away, the surviving spouse will be saddled with reporting all the capital gains.

Generous gift giving. Another method to realize capital gains is to give gifts of capital assets to adult children before June 25, 2024. Giving gifts now accomplishes many objectives such as realizing the gain at a lower rate, eliminating the asset from the deemed disposition at death, allowing the asset to grow in the next generation’s tax hands, and reducing the value of the estate subject to provincial probate fees. Individuals with cottages and other taxable real estate should consider giving a gift of the property or a portion of the property if the taxable accrued gain is significant. Using the installment capital gain reserve rules to sell a property to adult children may also be a consideration to spread the gain over a maximum of five years if not ready to give a gift before June 25, 2024. Unpaid debts for sales proceeds can be forgiven in a will.

Prescribed rate spousal loans. Income-splitting prescribed rate spousal loans lost popularity in the last year when the prescribed interest rate rose to 5 and 6 per cent. These loans are set up at market value terms and typically require a disposition of assets at fair market value for assets loaned in kind. Despite the current 6 per cent interest rate, taxpayers could consider a loan of assets at fair market value to trigger a capital gain to take advantage of the 50 per cent inclusion rate. This strategy will require careful planning to ensure it achieves a positive tax result for both taxpayers.

Donations of securities are still an option. The charitable community received a minor victory from the budget to increase the AMT donation tax credit from 50 per cent to 80 per cent. The budget did not propose to change the inclusion rate of 30 per cent of the capital gain on donated securities for AMT purposes.

Individuals not affected by AMT can manage their lifetime or death capital gains by continuing to benefit from the zero capital gains inclusion rate on securities donations and the regular donation tax credits at the federal and provincial levels. Contact your Raymond James advisor to learn more about charitable giving solutions through a charitable giving account.

It is now more important than ever to ensure that your testamentary instruments, such as your will, permit the estate administrator discretion over choosing to donate securities to reduce the terminal tax liability of the decedent and the estate. Contact your Raymond James advisor to connect with an estate planning professional to review your existing estate plan.

Departure taxes. Individuals planning to cease Canadian tax residency are also subject to the deemed disposition rules upon departure. There may be a very tight timeline to manage large capital gains to prevent departure gains from triggering the higher tax rates. It is now more important to plan a departure from Canada at least several years in advance to minimize capital gains taxes. Please contact your Raymond James advisor to schedule a pre-departure tax planning meeting with one of our tax consultants to discuss a planned move to another country.

The alternative minimum tax game. The budget also indicated the government’s intention to proceed with the January 1, 2024 changes to the alternative minimum tax (AMT) rules originally proposed in the 2023 budget. Capital gains were going to be significantly impacted because the new federal AMT rate of 20.5 per cent was more than the regular 16.5 per cent top federal rate on capital gains (33% x 50% inclusion). With the new inclusion rate, the regular top federal tax rate on gains will increase to 22 per cent (33% x 66.67% inclusion) on capital gains over $250,000. Therefore, there is less likelihood of a large capital gain triggering AMT because the AMT taxes on gains will be lower than regular taxes on or after June 25, 2024. It is possible that AMT may be triggered on large capital gains realized before that date, so a plan will be required to ensure the AMT is recoverable in the following seven years. Contact your Raymond James advisor to connect with one of our tax consultants regarding your concerns about AMT.

Corporations

Holding companies impacted. Corporations that hold passive investments and realize capital gains will be impacted by the increase to the inclusion rate. There is no $250,000 threshold for corporations, so every dollar of a capital gain will be subject to the 66.67 per cent inclusion rate. The effective federal tax rate on capital gains will increase from 19.33 percent (38.67% x 50% inclusion) to 25.78 per cent (38.67% x 66.67%) starting June 25, 2024. Shareholders should carefully consider if holding capital assets in a corporation for the long-term is an effective tax strategy under these new rules. After triggering capital gains, consider investing proceeds in corporate-owned insurance as part of the corporation’s tax strategy.

Smaller capital dividend account additions. The capital dividend account (CDA) is a notional account that allows corporations to pay out the non-taxable portion of a capital gain to shareholders as tax-free capital dividends. Instead of adding 50 per cent of all capital gains to the CDA, only 33.33 percent will be added, significantly reducing the amount of tax-free capital that shareholders can extract from a corporation. Investors with corporations should consider crystallizing gains before June 25, 2024 to take advantage of the lower tax rates and the additional CDA amounts. Then they should immediately pay a capital dividend to avoid reducing the CDA by future capital losses.

Small business grind. The higher capital gain inclusion rate will increase the adjusted aggregate investment income (AAII) calculation that is used to determine an active business corporation’s entitlement to the small business tax rates. The reduction applies to AAII in excess of $50,000. In other words, the new inclusion rates will grind down the small business exemption faster because it increases AAII.

Refundable dividend taxes on hand (RDTOH). The budget did not provide any commentary on changes to the RDOTH calculation. The existing rules provide for a refund of 15.33% of capital gains tax when the corporation pays a dividend. Assuming there are no changes to the refundable dividend tax calculation, the permanent (non-refundable) federal corporate tax will increase for capital gains earned inside a corporation from 4 per cent to 5.33 per cent.

AMT does not apply. As a reminder, corporations are not subject to alternative minimum tax, so realizing large capital gains and/or donating securities with accrued gains is a viable option for reducing taxes before the deadline. Donated securities will still receive a zero capital gains inclusion and a 100 per cent addition to the CDA to extract tax-free capital dividends. Contact your Raymond James advisor if you wish to connect with one of our tax or philanthropic professionals.

Trusts

Gains retained in the trust. Trusts also have no $250,000 threshold, so every dollar of a capital gain will be subject to the 66.67 per cent inclusion rate when the capital gain is taxed within the trust. The federal tax rate will increase from 16.5 percent (33% x 50% inclusion) to 22 per cent (33% x 66.67%). The top provincial tax rate will also apply to the new capital gain calculation. Trustees should consider realizing capital gains before June 25, 2024 if the trust intends to tax the capital gains inside trust.

Trusts are subject to alternative minimum tax. Even worse, trusts do not have the base exclusion of $173,205 that applies to individual taxpayers. Trustees must weigh the downsides of incurring AMT to tax capital gains inside a trust against the possible downsides of allocating income to beneficiaries to pay personal taxes on capital gains.

Income allocations to beneficiaries. Trustees should now consider how the allocation of capital gains to the beneficiaries will affect the beneficiary’s personal taxes. They may try to ensure that each beneficiary does not receive more than $250,000 in capital gains for the tax year. The trustee may want to consider the beneficiary’s personal capital gains realized during the year to determine the amount to allocate and when to allocate the capital gains. The timing of an annual capital gain allocation has historically not been relevant, but for 2024 it will likely be important to document the date of the allocation to fall within the pre-June 25, 2024 period. Trustees should discuss with their legal professionals and their tax professionals.

Capital distributions to beneficiaries. Trusts that are no longer required to protect assets on behalf of beneficiaries may consider distributing trust assets in kind to beneficiaries. Generally, a trust can roll out capital assets to a Canadian resident beneficiary at the trust’s original cost basis. Then the beneficiary pays income taxes on the capital gain when they decide to dispose of the asset. Trustees must now strategically consider either transferring out assets at cost or at fair market value, depending on the timing of the gain and the beneficiary’s personal tax situation.

Bigger problems for alter-ego and joint-partner/spousal trusts. The new capital gains rules pose a bigger tax problem for trusts classified as alter-ego and joint-spousal or joint-partner trusts. Upon death of the beneficiary or the last surviving spouse beneficiary, the capital gains realized must be taxed inside the trust at top federal and provincial capital gains tax rates. The date of death capital gains are not allocable to the beneficiaries to be taxed on their terminal tax return. Furthermore, donations of securities from the trust are not eligible for the zero capital gains exemption, even though they are eligible for the donation tax credit. Trustees must now actively manage capital gains realizations to reduce the capital gains taxes at death that will be taxed higher than an individual taxpayer. Consider realizing gains before June 25, 2024 and consider withdrawing capital assets so that the original beneficiaries can personally donate securities in current and future years before mortality.

Estates. The budget did not distinguish any separate trust capital gains rules for graduated rate estates (GRE). Presumably, the 66.67 per cent inclusion rate will apply when an estate sells a capital property and then graduated rates will apply. It is unclear if a GRE receives the $250,000 capital gains 50 per cent threshold. If an estate is planning to liquidate assets, it likely makes sense to sell the assets before June 25, 2024 to ensure the estate and/or the beneficiaries can benefit from the lower inclusion rate without relying on the $250,000 threshold.

Summary

The pace of tax change continues to accelerate, and the changes continue to introduce complexity into the Canadian tax system. The changes to the capital gains inclusion rate will have a domino effect on all types of taxpayers. It is important to review your situation as soon as possible to determine if it is a good strategy to realize capital gains in the short period that the government has provided. It is unprecedented for the government to provide a window of time for tax planning, however that may have been by design to encourage significant gain realization events to collect more taxes in 2024. Our Total Wealth Solutions teams are standing by to help you navigate your specific situation.

This has been prepared by the Total Wealth Solutions Group of Raymond James Ltd., (RJL). Statistics and factual data and other information are from sources RJL believes to be reliable but their accuracy cannot be guaranteed. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities nor is it meant to replace legal, accounting, taxation or other professional advice. We are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax-related matters. The information is furnished on the basis and understanding that RJL is to be under no liability whatsoever in respect thereof. This is intended for distribution only in those jurisdictions where RJL and the author are registered. Securities-related products and services are offered through Raymond James Ltd., Member - Canadian Investor Protection Fund. Insurance products and services are offered through Raymond James Financial Planning Ltd., which is not a Member - Canadian Investor Protection Fund.