Increase to the Capital Gains Inclusion Rate

In the Federal Budget released on April 16, 2024, it was announced that the capital gains inclusion rate will be increased from 1/2 to 2/3 effective June 25, 2024. Currently, only 1/2 of capital gains are included in taxable income. With the top marginal tax rate of 15% in Alberta and 33% Federally, capital gains under the current 1/2 inclusion rate are taxed at a combined top marginal tax rate of 24% (1/2 of the top rate of 48%). On and after June 25, 2024, any capital gains subject to the new 2/3 inclusion rate will instead have a combined top marginal tax rate of 32% (2/3 of 48%).

Assuming the budget passes as proposed (which is still not certain), this gives taxpayers approximately two months to take advantage of the current inclusion rate.

Who does the new inclusion rate apply to?

It applies to corporations, trusts (including estates), and individuals. However, individuals will receive a bit of relief as the 2/3 inclusion rate will only apply to capital gains exceeding $250,000 per year. The $250,000 threshold will include capital gains net of:

1. current year capital loses applied to the current capital gains;
2. carry forward or carry back capital losses from other years applied to the current capital gains;
3. capital gains where the following exemptions were claimed:
   1. Lifetime Capital Gains Exemption, which is being increased to $1.25 million;
   2. new proposed Employee Ownership Trust Exemption;[1] and
   3. new proposed Canadian Entrepreneurs Incentive. [2]

Implications of the Increased Inclusion Rate

The change in capital gains inclusion rate will have both immediate and long-term effects on Canadians.

Short Term Considerations

Corporations and trusts, and even some individuals, with large unrealized capital gains may wish to consider disposing of some of their capital assets prior to June 25, 2024, to trigger capital gains tax with the 1/2 inclusion rate. Where an arm’s length sale is not convenient, an internal reorganization to trigger the capital gains may be considered.

Long Term Considerations

1. The tax cost of earning capital gains in corporations will increase, reducing the tax deferral advantage of leaving savings in corporations. These tax costs will be direct and indirect.
   
   

   The obvious direct cost is the higher tax on capital gains. This will particularly cost corporations which earn significant capital gains, notably corporations holding significant investments, or which regularly buy and sell real estate as capital assets, such as property rental corporations.

   However, there will be indirect costs as well. Certain qualifying corporations are able to utilize the small business deduction (“SBD”) to reduce their corporate tax rate. The SBD has an annual maximum of $500,000 for a corporation and all its associated corporations, and this maximum begins to decrease when the associated corporations’ aggregate investment income exceeds $50,000.[3] The SBD is decreased to $0 once the associated corporations’ aggregate investment income equals or exceeds $150,000. Currently, aggregate investment income only includes 1/2 of capital gains under the current inclusion rate. However, upon the inclusion rate increase, the aggregate investment income will then include 2/3 of capital gains. This means the aggregate investment income will grow faster due to more capital gains being included in its calculation, which then means the SBD will be decreased at a quicker pace.

   Put together, corporations will need to consider whether it makes more sense to pay amounts out to individuals, giving up the tax deferral, but allowing them to take advantage of the $250,000 threshold for personal capital gains and help allow their corporation to maintain access to the SBD.
   

2. Although the $250,000 threshold for individuals sounds relatively high, even if it does not catch most individuals most of the time, it may catch many occasionally.
   
   

   While most individuals will not earn $250,000 of capital gains every year, this change will affect people when they have significant sales of capital assets which may only happen occasionally. This includes sales of a business or real estate not covered by the principal residence exemption.

   It is not yet clear whether capital gains could be spread out through the use of existing tax provisions, such as the capital gains reserve, or whether the CRA would accept plans that deliberately crystalize capital gains prior to arm’s length sales. However, there will now be strong tax incentives for individuals to spread capital gains out over multiple years to have more of them covered by the $250,000 lower inclusion amount.
   

3. This will increase tax on death for those with unrealized capital gain in excess of $250,000.

   
   Upon death, an individual is deemed to have disposed of all their assets. This often realizes capital gains in one fell swoop. The higher inclusion rate will impact the taxes that estates will pay.

   From a planning perspective, if individuals had purchased insurance policies to help fund the payment of tax upon their death, they may need to revisit whether the insurance payout will still be sufficient with the higher capital gains tax.

   Individuals who had created estate plans with the intention of equalizing with different types of assets being gifted to different beneficiaries may also need to revisit their plans, as their estates could now be subject to higher taxes. Specifically, there will be less “cash and cash equivalent” assets left after taxes are paid to gift to those who are to receive these “cash” gifts; in contrast, the beneficiaries receiving “in-kind” gifts will be less likely to be impacted because taxes are usually paid from liquid assets first. An example would be farmland and farm equipment being gifted to a farming child while the non-farming children are to receive cash gifts.
   

4. This will further change when alternative minimum tax (“AMT”) applies.
   
   The AMT calculation is a parallel tax calculation that is done alongside the ordinary calculation of taxable income. If the AMT calculation results in higher tax compared to the ordinary calculation of taxable income, then higher tax, being AMT, must be paid instead of the ordinary tax. The excess amount between AMT and ordinary tax can be claimed as a tax credit over the subsequent 7 years.

The Government recently just changed AMT and we are still wrapping our heads around those changes. These changes will further impact those calculations.

Notably, when the increase to the capital gains inclusion rate applies, it is less likely AMT will need to be paid because the “ordinary calculation” of taxable income will be higher. However, AMT will still apply when claiming the lifetime capital gains exemption or the proposed Canadian Entrepreneur’s Incentive, which will reduce the benefits of these increased amounts.

Conclusion

There are still several aspects regarding the increase to the inclusion rate that must be clarified but, assuming this change will be passed into law, it will have a significant impact both in increasing total taxes and the resulting tax planning considerations. In the short term, owners of capital assets should consider whether it makes sense to trigger their unrealized capital gains before the changes go into effect on June 25, 2024.

If you have any questions or would like to discuss how these changes impact you or your business, please reach out to any member of our Tax Group.

Please look out for our separate article where we summarize the less time sensitive changes in the budget in the coming days.