Background
On June 10, 2024, the Ministry of Finance released a Notice of Ways and Means Motion (NWMM) to amend the Income Tax Act and Income Tax Regulations to implement the Budget 2024 initiative to increase the capital gains inclusion rate. Starting June 25, 2024, the capital gains inclusion rate was originally proposed to be adjusted as follows:
- For corporations and trusts: The capital gains inclusion rate will be increased from 1/2 to 2/3.
- For individuals: For capital gains that exceed an annual threshold of $250,000, the capital gains inclusion rate will be increased from 1/2 to 2/3.
The NWMM provides an overview of various measures introduced by the government to implement the higher capital inclusion rate proposed in the Budget 2024. This article will focus on measures impacting middle market taxpayers.
Little relief offered despite requests from numerous interested parties
In a related press release by the Department of Finance, certain suggestions put forth by interested regulatory parties were quelled, offering the following summary of the changes:
- No changes to the principal residence exemption.
- No ability to elect to internally trigger capital gains in anticipation of the June 25 deadline.
- No ability to average capital gains over multiple years to stay under the $250,000 threshold.
- No ability to split the $250,000 threshold with corporations.
- No exceptions for specific assets or types of corporations.
- No distinction based on how long an asset is held or otherwise.
On top of the summary above, the Department of Finance also released a more comprehensive summary of the changes.
New draft legislation
Transitionary rules for the new capital gains inclusion rate
The draft legislation acknowledged that the inclusion rate increase date of June 25, 2024, being in the middle of many ordinary taxation years, offers complications. As a result, the draft legislation introduces transitionary measures to identify how the inclusion rate will be applied based on a taxpayer’s individual circumstances. Firstly, the draft legislation separates out a taxation year between two relevant periods:
- The beginning of the taxation year until the end of the day June 24, 2024 (“Period 1”); and,
- The beginning of the day June 25, 2024 until the end of a taxpayer’s taxation year (“Period 2”)
Taxpayers would then need to net capital gains against capital losses for each period to determine whether that particular period yielded either a cumulative net capital gain or net capital loss. Then, the following capital gains inclusion rates would apply:
- If a taxpayer only has net capital gains or net capital losses in Period 1 and Period 2, a 1/2 inclusion rate would apply for gains/losses incurred in Period 1 and a 2/3 inclusion rate would apply for gains/losses incurred in Period 2.
- If a taxpayer has no net capital gains or net capital losses in either period, a 2/3 inclusion rate would apply for all gains/losses.
- If a taxpayer has net capital gains in Period 1 that exceed net capital losses in Period 2, a 1/2 inclusion rate would apply for all gains/losses.
- If a taxpayer has net capital losses in Period 1 that exceed net capital gains in Period 2, a 1/2 inclusion rate would apply for all gains/losses.
- If a taxpayer has net capital gains in Period 1 that are less than net capital losses in Period 2, a 2/3 inclusion rate would apply to all gains/losses, to the extent not sheltered by the $250,000 threshold.
- If a taxpayer has net capital losses in Period 1 that are less than net capital gains in Period 2, a 2/3 inclusion rate would apply for all gain/losses.
Interested parties should consider reading the draft legislation for specific timing considerations that may apply to their situation when trying to determine whether certain gains/losses arise during Period 1 or Period 2.
New $250,000 threshold for individuals
Individuals (excluding most trusts) will be able to shelter the first $250,000 of their capital gains to remain taxable at 1/2 even after June 24, 2024. This threshold would apply to all capital gains incurred on or after June 25, 2024 and will be net of any capital losses for the year, the lifetime capital gains exemption, the employee ownership trust tax exemption, and the proposed Canadian entrepreneurs’ incentive. This threshold will be algebraically determined by multiplying the threshold by 1/6 and allowed as a deduction from taxable capital gains, allowing for an effective 1/2 inclusion rate. Note that this threshold will not be prorated for 2024.
Capital gains reserves
Under certain circumstances, taxpayers are able to defer the recognition of capital gains in situations where the proceeds of the sale of capital property are received over a number of years. In these circumstances, a capital gain is realized in income with a reserve being taken based on the amount of proceeds that have not yet been received, with a minimum of 10% or 20% of the gain to be brought into income each year (depending on the type of asset sale and subject to the new draft intergenerational transfer rules). The reserve enters into taxable income in the following year.
For purposes of the capital gains inclusion rate change, reserves will be considered to enter into income on the first day of the taxation year. This means that taxation years that begin before June 25, 2024 will have that capital gain subject to a 1/2 inclusion rate. As the reserve enters into income in subsequent years, the prevailing capital gains inclusion rate for that year would apply (i.e., possibly 2/3). In other words, the capital gains inclusion rate on the actual date of sale does not get maintained as the reserve is utilized.
Net capital loss carryforwards
Net capital losses can be carried back three years and forward indefinitely to offset capital gains in other years, with adjustments made to reflect the applicable inclusion rate. For example, net capital losses incurred when the inclusion rate was 1/2 and utilized when the capital gains inclusion rate is 2/3 will be multiplied upwards to 4/3, in order to allow the relevant capital loss to offset an equivalent capital gain regardless of inclusion rates.
Employee stock option deduction
Under the current rules, when an employee exercises a stock option, the difference between the fair market value of the stock and its exercise price results in a taxable benefit (the “stock option benefit”) and is included in the employee’s income. Where the employer is a Canadian-controlled private corporation (CCPC), the stock option benefit arises at the time the shares are ultimately disposed of or exchanged by the employee. Generally, the taxation of employee stock options in Canada mirrors the taxation of capital gains and hence, the employees can claim a stock option deduction at the rate of 1/2 of the stock option benefit.
Consequent to the proposed amendment to the inclusion rate, the stock option deduction would be 1/3 of the stock option benefit for stock options exercised (or disposed of or exchanged in case of a CCPC) on or after June 25, 2024. The annual $250,000 limit described above would apply to the total amount of stock option benefit and capital gains for a particular taxation year. In a situation where the total stock option benefit and capital gains exceed $250,000, the taxpayer would have the discretion to choose the preferential tax treatment (lower inclusion rate) for allocating the amounts.
Allowable business investment losses
A business investment loss arises when bad debt arises on the amount owed by a small business corporation (SBC) or the shares of a bankrupt SBC are disposed of. 1/2 of the capital losses, referred to as allowable business investment losses (ABIL), can be used to offset other income like income from business, property, and employment. Any unused ABIL can be used to offset income from any source and can be carried back three years and carried forward 10 years. Any amount of ABIL remaining after 10 years gets converted to an ordinary capital loss that can be carried forward indefinitely and used to offset only capital gains.
With the increase in the capital gains inclusion rate, 2/3 of business investment losses realized on or after June 25, 2024, would be deductible. Furthermore, unlike other capital losses carried over, ABILs would not be adjusted in value to reflect the new inclusion rate that applies in the year the loss is claimed. In other words, ABILs realized on or after June 25, 2024 would be determined based on the 2/3 inclusion rate even if carried back and applied in any of the three previous years.
Partnership allocations and trust designations
Generally, partnerships calculate net income as if they are a taxable entity for Canadian tax purposes. The income is then allocated to the partners based on the partnership agreement. Capital gains earned in a partnership are typically transferred out as taxable capital gains for the year. For partnerships that have capital gains in a fiscal period that straddle June 25, 2024, those taxable capital gains, allowable capital losses, or ABILs will instead be grossed up back to the original amount and deemed to be realized by the relevant partner. Partnerships would be required to disclose to partners which gains arose during which period, to potentially allow access to the $250,000 threshold.
Trusts are taxable entities for Canadian tax purposes and compute taxable income accordingly. Trusts can allocate its income to beneficiaries at the end of the trust’s taxation year, and also preserve the character of the income for beneficiaries, to allow them to take advantage of various tax preferred treatments. For trust taxation years that straddle June 25, 2024, trusts would similarly gross-up their net capital gains back to their original amount and have them deemed to be recognized by the relevant beneficiary. Trusts would be required to disclose to those beneficiaries which gains arose during which period, with certain simplifying calculations for commercial trusts.
International tax adjustments
Certain international tax measures will be adjusted to be brought in line with the change in capital gains inclusion rate, including:
- Computing the foreign accrual property income of a foreign affiliate and deductions for dividends received from a foreign affiliate’s hybrid surplus.
- The withholding tax rate for non-residents disposing of taxable Canadian property will increase from 25% to 35%, effective for dispositions occurring on or after Jan. 1, 2025.
Only two weeks left for implementation
Overall, the changes to the capital gains inclusion rate and related measures remain largely unchanged from when they were originally announced in Budget 2024. Despite updated draft legislation being expected at the end of July, it is not expected to affect the new measures significantly. Taxpayers are only left with two weeks to finalize any tax planning they would like to implement prior to June 25, 2024, after which they should expect a significantly different tax landscape for capital gains in Canada.
