Plan ahead to overcome increased capital gains inclusion rate

Effective June 25, 2024, Federal Budget 2024 proposed to increase the capital gains inclusion rate from 50% to 66.67%. The increased rate will lead to a higher tax liability for taxpayers owning assets such as shares, bonds, multiple properties etc. upon disposal of such assets with a realization of a capital gain. Individuals with excess capital gains above the annual threshold of $250,000 are to be taxed at a higher rate. However, for corporations and trusts, the higher rate will apply to all the capital gains beginning the proposed date. As the effective date of the amendment is just few weeks away, taxpayers need to be proactive and undertake tax planning and optimization strategies to make sure that the higher rate doesn’t come as a surprise to them later on.

Plan ahead to overcome increased capital gains inclusion rate

Background

Canada’s 2024 Federal Budget (Budget 2024), tabled on April 16, 2024, introduced significant changes to the taxation of capital gains. Among these changes, the most notable is the increase in the inclusion of capital gains in taxable income, which under the current rules provides a 50% inclusion rate.

Taxpayers owning assets like stocks, bonds, rental properties, a secondary home, or even business equipment will be impacted by the amendment if they dispose of such assets and realize a capital gain.

Capital gains arising from the sale of the principal residence will not be impacted by the proposed amendment and will remain tax-free.

Proposed inclusion rate changes in Budget 2024

Budget 2024 proposes to amend the capital gains inclusion rate for capital gains realized on or after June 25, 2024, as below:

The value of net capital losses from previous years will be adjusted to align with the inclusion rate applicable to the capital gains being offset.

To facilitate the amendment, transitional rules will apply to taxation years that begin before and end on or after June 25, 2024:

• Capital gains realized before June 25, 2024 would be subject to the 50% inclusion rate; and,
• Capital gains realized on or after June 25, 2024 would be subject to a 66.67% inclusion rate.

The proposed transitional rules will ensure that the $250,000 threshold is not prorated in 2024 and will apply only against capital gains realized on or after June 25, 2024.

Budget 2024 also proposes to amend the taxability of the employee stock options (ESO). Generally, the taxation of ESOs in Canada mirrors the taxation of capital gains, except if the ESO relates to certain large corporations. Under the current rules, employees are generally entitled to a deduction of 50% of the taxable benefit arising from the qualifying stock options, resulting in a net 50% inclusion of the ESO taxable benefit in the taxable income. However, with the proposed amendment, the ESO deduction will also be reduced from 50% to 33.33%, to the extent that both the ESO taxable benefit and capital gains exceed $250,000.

Tax implications

The increase in the capital gains inclusion rate will change the effective rate of tax on the capital gains realized by the taxpayers on or after June 25, 2024. The effective change in tax rates due to these proposed changes is summarized below:

*For individuals, this rate applies to capital gains in excess of the proposed $250,000 threshold. For capital gains of $250,000 or less, the highest marginal tax rate would remain the same at 26.77%.

Planning opportunities

RSM can assist taxpayers in taking proactive measures before the proposed capital gains inclusion rules take effect on June 25, 2024 to minimize tax on capital gains. Examples of planning opportunities in light of the amendment can include:

Accelerating transaction timelines (e.g., sales, reorganizations, estate freezes, etc.)

Taxpayers who are currently in the process of selling a capital asset such as business equipment, stocks, or undertaking a corporate reorganization/estate freeze may consider accelerating the timeline of their transactions to close before June 25, 2024. Business owners considering an intergenerational transfer of their business under the rules introduced by Bill C-208 may want to consider closing before June 25, 2024.

Preparing tax plans and/or reviewing current draft plans will ensure the optimal timing of transactions.

Crystalizing capital gains before June 25, 2024 and utilizing tax attributes or exemptions

Where it is not feasible for taxpayers to accelerate the timelines of their transactions, taxpayers may consider crystallizing the inherent capital gains before June 25, 2024. Mitigation strategies such as the lifetime capital gains exemption or maximizing the utilization of carry-forward capital loss balances should be assessed to minimize the taxes on capital gains.

Maximizing carrybacks of capital losses – now vs. defer?

The value of net capital losses from previous years will be adjusted to align with the applicable inclusion rate. Therefore, taxpayers may wish to consider deferring the utilization of losses carried forward over the next few years as they will be more valuable when used against the capital gains realized at a higher rate. Modeling the utilization of carry-forward capital losses for future years can be undertaken to minimize anticipated tax costs.

Optimal structure of holding capital assets – corporations, individuals, trusts, partnerships, or a combination thereof?

Individuals who do not expect to earn capital gains exceeding the $250,000 threshold may want to consider holding their investments directly rather than a corporation as corporations will not have a minimum threshold under the proposed changes. Actions to take now include modeling the optimal structure of holding assets considering future capital gains, capital loss balances, and/or exemptions.

Revisiting estate plans

Budget 2024 was notably silent on whether any exceptions will be made for capital gains arising on death under the proposed changes. Generally, the death of a taxpayer triggers the deemed disposition of all the taxpayer’s assets at fair market value, resulting in realized capital gains. Consequent to the amendment, such deemed disposition will lead to higher taxes on death. Individuals should revisit existing estate plans in light of the higher inclusion rate to account for the increased tax liability upon death.

Only 8 weeks left to plan

The capital gains amendment underscores the need for preemptive tax planning. Although no legislation currently exists and the proposed changes may undergo further revisions, the new rules are proposed to be effective in less than two months. This leaves a short window for taxpayers to assess their portfolios, explore tax-optimization opportunities, and strategize their next course of action.