Increase To The Capital Gains Inclusion Rate – Capital Gains Tax

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.

Footnotes

1. We will discuss this in more detail in a later article
on the 2024 Budget. Generally, this proposed Employee Ownership
Trust Exemption will be available for a shared $10,000,000 of
capital gains on the disposition of shares with respect to the
corporation under this trust. However, there are numerous criteria
that must be satisfied to claim this exemption.

2. We will discuss this in more detail in a later article
on the 2024 Budget. Generally, this proposed Canadian Entrepreneur
Incentive will reduce the inclusion rate by 50% for
eligible capital gains (2/3 to 1/3 and 1/2 to 1/4) from the sale of
a business, up to a lifetime maximum of $2,000,000. This incentive
is intended to start in 2025 with a $200,000 maximum in 2025; this
maximum will increase by $200,000 each year until it reaches
$2,000,000 in 2034. There are numerous criteria that must be
satisfied to be considered eligible capital gains for this
exemption such that it will likely only be available to
a very limited number of people.

3. The SBD is also reduced if the associated
group’s taxable capital employed in Canada exceeds
$10,000,000

Because of the generality of this update, the information
provided herein may not be applicable in all situations and should
not be acted upon without specific legal advice based on particular
situations.

© Morrison & Foerster LLP. All rights reserved

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