Navigating the capital gains inclusion rate increase

As per the 2024 federal budget, the capital gains inclusion rate is scheduled to increase from one-half (50%) to two-thirds (66.67%) for capital gains realized on or after June 25, 2024 (“effective date”). This article summarizes the potential impact of this increase for your clients.

Corporations

Each $1 of capital gains realized in Canadian corporations after the effective date would be subject to the higher inclusion rate. If your clients are looking to sell investments in their private corporation, the increase in inclusion rate would mean their corporate taxes would increase from 25.08% to 33.45% (assuming Ontario rates) resulting in higher corporate tax liability. So, should your clients be triggering capital gains prior to June 25, 2024?

One way to make the decision is to consider the after-tax cash flow that your client can receive under both options, thus considering both corporate and personal tax liability. Based on 2024 tax rates in Ontario (see Illustration 1), your clients would likely pay 38.62% in total personal and corporate tax to withdraw funds from their private corporation if they crystalize the capital gains after June 24, 2024. This is an increase of 9.65% compared to the current combined corporate and personal tax rate of 28.97%. Therefore, if your clients are looking to rebalance their corporate portfolio or sell corporate investments to withdraw cash for their personal expenses in 2024, it may be more tax-efficient for them to realize the capital gains prior to the effective date. On the other hand, if your client intends to hold the corporate investments over the long-term, then deferring the crystallization of capital gains could provide greater after-tax returns.

The changes to the capital gains inclusion rate will also impact integration. Under the theory of integration, the total taxes paid on income earned by an individual should be equal to the total taxes paid by earning income through a corporation. If we compare the combined corporate and personal tax rates with the top personal tax rates on capital gains, the proposals will increase the tax cost of earning capital gains through a private corporation, (see Illustration 2). In other words, it may now be more tax advantageous to earn capital gains directly as an individual, especially for the first $250,000 of capital gains realized annually as discussed below.

Individuals

Under the proposed changes, individuals will still have access to the lower 50% capital gains inclusion rate on the first $250,000 of capital gains realized in each calendar year, and any excess would be subject to the 66.67% inclusion rate, which essentially represents a 33% increase in effective tax rates across Canada. Despite this tax rate increase, it may not always be tax efficient for your client to crystallize all accrued capital gains prior to the rule changes.

One way to determine the optimal strategy is to look at the tax savings from triggering the capital gains earlier compared to the loss of tax-deferred returns on the cash used to prepay taxes. The comparison can be used to calculate a “break-even period” — the minimum years of tax-deferral growth required to generate an after-tax return greater than the tax savings.

As an example, let’s assume your client wants to decide whether they should take advantage of the lower capital gains inclusion before June 25 and trigger the full $350,000 of capital gains in their non-registered portfolio. It is important to remember that the first $250,000 of capital gains realized before or after June 25 would benefit from the same 50% capital gains inclusion rate. The difference lies in the taxation of the remaining $100,000. If this amount is taxed before June 25, it would result in an incremental tax liability of $26,765 (assuming your client is subject to the top marginal tax rate in Ontario). This incremental tax liability would increase to $35,687 if realized after June 24, 2024. Thus, there are potential tax savings of $8,922 by triggering the capital gains prior to the rule changes.

So, what is the “break-even period” in this example? If the taxes were not triggered, it would take roughly seven years of deferred capital gains growth (compounded annually at 6% rate of return) to break even with the tax savings. In other words, if investments would otherwise be kept invested for at least 7 years earning compounded growth at 6%, your client would likely end up with more after-tax dollars. Therefore, if your clients do not plan/need to liquidate their investments prior to the break-even period, they may still be better off to defer the taxes despite the higher capital gains inclusion rate in the future!

As there are many factors in determining the optimal solution for your clients, it would be important for your clients to work through the detailed calculations with their tax advisors based on their specific circumstances.

Illustration 1: Combined corporate and personal tax rate on distributing capital gains realized in a private corporation in Ontario

Illustration 2: Combined corporate and personal tax rates compared to top personal tax rates for capital gains in select provinces across Canada

This should not be construed as legal, tax or accounting advice. This material has been prepared for information purposes only. The tax information provided in this document is general in nature and each client should consult with their own tax advisor or accountant. We have endeavored to ensure the accuracy of the information provided at the time that it was written, however, should the information in this document be incorrect or incomplete or should the law or its interpretation change after the date of this document, the advice provided may be incorrect or inappropriate. There should be no expectation that the information will be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise. We are not responsible for errors contained in this document or to anyone who relies on the information contained in this document. Please consult your own legal and tax advisor.