An increase in Canada’s capital gains inclusion rate (CGIR) could have significant repercussions for taxpayers and businesses engaged in cross-border transactions. The CGIR is poised to increase from one-half to two-thirds for all taxpayers, with individual taxpayers able to retain a one-half effective inclusion rate on the first $250,000 of capital gains earned annually. Initially set to be effective for dispositions occurring on or after June 25, 2024, Finance recently deferred the proposed effective date for this change to January 1, 2026. However, recent political developments—including the resignation of the prime minister and the proroguing of Parliament—could jeopardize the formal implementation of this change. Notably, with Parliament now tentatively prorogued until March 24, 2025, there is a possibility that the proposed amendments may not proceed at all as initially planned.
Beyond its domestic tax impacts, the CGIR introduces far-reaching cross-border changes for taxpayers dealing with taxable Canadian property (TCP), foreign affiliates (FAs), and surplus calculations. These amendments will also have an impact on international tax planning, compliance requirements, and strategic decision making for affected stakeholders. The deferral provides taxpayers with additional time for undertaking a detailed review of their investment portfolios and adjusting their strategies in order to mitigate the heightened tax liabilities under the new framework. This process should include identifying opportunities for pre-emptive restructuring and optimizing asset management to align with the updated inclusion rate.
Key Implications
Withholding Tax on TCP dispositions
The increase to the CGIR also places greater pressure on withholding obligations for TCP dispositions. Pursuant to current section 116 of the ITA, and excluding the additional withholding for “taxable Quebec property,” non-residents disposing of TCP are typically subject to a 25 percent withholding on the property’s value, which increases to 50 percent in certain circumstances. The 25 percent withholding rate was supposed to increase to 35 percent for dispositions occurring on or after January 1, 2025, unless specific exemptions apply. No draft amendments are in place to adjust the 50 percent withholding rate. Although non-resident taxpayers can still mitigate the withholding via a clearance certificate and withhold, instead, on the basis of the underlying capital gain, this change increases the upfront tax remittance required at the time of disposition and reduces net returns for non-residents. However, it is important to note that, in contrast to Finance’s directives regarding the deferral of the revised CGIR, no formal guidance exists on whether taxpayers should withhold (until political instability is resolved) 35 percent for dispositions of TCP occurring on or after January 1, 2025, or whether the implementation of the higher withholding tax rate is also deferred to 2026.
To ensure compliance and minimize potential penalties, non-residents disposing of TCP on or after the date the higher withholding tax rate is effective should ensure that they
- comply with section 116 of the ITA, including by filing timely clearance requests to mitigate withholding tax; and
- consider filing a tax return in Canada and paying tax on the basis of the increased CGIR of two-thirds, if it makes sense to do so.
Adjustments to FAPI
The increased CGIR also has an impact on foreign accrual property income (FAPI), affecting how capital gains realized by FAs are categorized and taxed in the hands of a Canadian parent company. In particular, when FAs compute capital gains from the disposition of property other than excluded property (and, in some cases, even from the disposition of excluded property), FAPI for the Canadian parent will be higher because of the increased CGIR.
Moreover, when the pre-acquisition surplus dividend exceeds the shareholder’s adjusted cost base (ACB) in the shares of the FA, negative ACB can arise, triggering a gain under subsection 40(3) of the ITA. With the increased CGIR, the taxable portion of these gains will increase. Similarly, the exempt dividend stop-loss rules under subsections 93(2.01), (2.11), and (2.31) will also reflect a change in the allowable capital loss ratio from one-half to two-thirds, while subsection 93(2.21) is proposed to be amended to reflect an update to the inverse of the CGIR from 2 to 1.5.
To prepare for these changes, Canadian taxpayers must
- evaluate FA structures to minimize mismatches between FAPI inclusion and the availability of foreign tax credits so as to proactively address the higher CGIR on non-excluded property gains; and
- avoid potentially negative ACB situations in order to mitigate larger subsection 40(3) gains while maintaining awareness of the updated stop-loss provisions.
Implications for Surplus Calculations
The CGIR and its impact on FAPI also have an indirect influence on the calculation of taxable surplus. As a result, under the new CGIR, the taxable portion of capital gains from non-excluded property (two-thirds) will flow into taxable surplus via FAPI, while the non-taxable portion (one-third) will be allocated to exempt surplus. This represents a notable reduction of the exempt surplus pool.
The definition of “hybrid surplus” in regulation 5907(1) of the Income Tax Regulations generally includes the entire capital gain earned by an FA when it disposes of shares of another FA that are classified as excluded property. Under the amendments, hybrid surplus is proposed to be bifurcated into two distinct surplus pools: “legacy hybrid surplus” and “successor hybrid surplus.” Capital gains realized by an FA before the effective date are to be classified as legacy hybrid surplus, while those realized on or after the effective date are categorized as successor hybrid surplus. Similarly, the definitions of “hybrid underlying tax,” “legacy hybrid underlying tax,” and “successor hybrid underlying tax” are proposed to be updated to account for the change.
In addition, draft amendments are proposed to the ordering rules under regulation 5901(1). As a result, dividends should continue to be paid, first from the exempt surplus (net of any blocking deficits) and then from the hybrid surplus (net of any blocking deficits). Dividends paid from hybrid surplus will be attributed first to the FA’s legacy hybrid surplus (up to its available balance), with any remaining amount allocated to the successor hybrid surplus. Consequential updates are also proposed to regulation 5900 to account for the new surplus pools.
Section 113 of the ITA, which provides a deduction for dividends received from FAs, is also proposed to be amended to reflect the hybrid surplus pool from which a dividend is prescribed to be paid. The purpose of this amendment is to ensure that any hybrid surplus dividends arising from capital gains earned by the FA on or after the effective date are afforded only a one-third deduction, and that hybrid surplus dividends that arose under the lower CGIR are allowed a one-half deduction.
The increased CGIR could influence both hybrid and taxable surplus, which may affect repatriation strategies. Therefore, taxpayers must
- identify opportunities to distribute exempt surplus to reduce overall tax liabilities, and
- consider more closely the generation of hybrid underlying tax on dispositions of shares of FAs that occur after the effective date.
Impact on Upstream Loans
The amendments also address the tax treatment of upstream loans made by an FA to Canadian parent corporations. The formulas used to calculate a deduction under subsection 90(9) of the ITA are proposed to be amended to incorporate the legacy hybrid underlying tax and successor hybrid underlying tax. This change ensures the accurate allocation of tax consequences between pre- and post-effective-date hybrid surplus.
Regarding upstream loans denominated in a foreign currency, there is also a risk of (among other possible concerns) a character mismatch. Although the taxable amounts of gains and losses may be the same, a gain on the affiliate side is treated as income, whereas a loss on the taxpayer side may give rise to a non-deductible capital loss. And a loss on the affiliate side cannot be offset at all against a gain on the taxpayer side.
To comply with these changes, taxpayers must
- monitor dividend distributions and surplus allocations to prevent unintended tax consequences on upstream loans, and
- carefully consider the timing and foreign exchange implications of repayments.
Key Points Regarding Compliance and Strategic Planning
Businesses with cross-border operations will face greater complexity under the revised CGIR framework. To navigate these changes effectively (while remaining mindful of any reversals or further changes that may be announced), taxpayers should consider the following strategies:
- Assess transaction timing. Align the sale of TCP with favourable withholding tax rates and surplus classifications.
- Leverage exempt surplus. Optimize the use of exempt surplus to mitigate tax liabilities on distributions from other surplus pools.
- Restructure investments. Revisit existing tax-planning strategies to ensure compliance and minimize exposure to the increased CGIR.
The proposed increase in Canada’s CGIR introduces a complex array of changes that demand careful attention from taxpayers and businesses operating across borders. By staying informed and implementing strategic planning measures, taxpayers can mitigate the potential tax burden and navigate the evolving regulatory landscape effectively.
