Increased capital gains will result in more financial pains.
Hemal Balsara is head of the Tax, Retirement & Estate Planning Services team with the Manulife Insurance team,
providing case level support on tax and estate planning matters to advisors across Canada.
After years of speculation, the 2024 federal budget tabled by Finance Minister Chrystia Freeland on April 16 was finally the budget that included a proposed increase to the capital gains inclusion rate. The budget also covered some relief for higher capital gains taxes through an increased lifetime capital gains exemption (LCGE), sales of business to employee ownership trusts (EOT), and the introduction of the Canadian Entrepreneurs’ Incentive (CEI).
Capital gains inclusion rate
Budget 2024 proposes to increase the capital gains inclusion rate from one-half to two-thirds for corporations and trusts for capital gains realized on or after June 25, 2024. For individuals, the inclusion rate will remain at one-half on the first $250,000 of capital gains realized and two-thirds on the portion of capital gains realized in the year that exceed $250,000 on or after June 25, 2024.
The $250,000 threshold would effectively apply to capital gains realized by an individual either directly or indirectly through a partnership or trust, net of any capital losses (current or applied from other years) and capital gains where the LCGE, the proposed EOT exemption, or the proposed CEI is claimed.
The rules will allow net capital losses realized prior to the rate change to fully offset an equivalent capital gain realized after the rate change.
In addition, for tax years that begin before and end on or after June 25, 2024, two different inclusion rates would apply―one-half before June 25, 2024, and two-thirds on or after June 25, 2024. The annual $250,000 threshold for individuals will be fully available with no proration.
Capital gains related to the sale of real estate in which the principal residence exemption was used, won’t be affected by these changes and will continue to be exempt from tax regardless of the dollar value of the capital gain.
Where an individual claims the employee stock option deduction, the budget provides a one-third deduction of the taxable benefit to reflect the new capital gains inclusion rate, but that individual would be entitled to a deduction of one-half the taxable benefit up to a combined limit of $250,000 for both employee stock options and capital gains.
These changes may have a material impact on a variety of different issues relating to tax and estate planning (subject to draft legislation being issued), as follows:
- Terminal tax obligations may be greater for taxpayers overall.
- The calculation of capital dividend account (CDA) amounts to corporations. Where the capital gains inclusion rate is two-thirds (meaning only one-third of the gain is nontaxable), only one-third of the gain will get credited to the CDA.
- It may also affect postmortem planning to minimize double taxation on the death of a private corporation shareholder.
- Life interest trusts won’t be eligible for the $250,000 exemption. This can create greater terminal tax liabilities in these trusts relative to owning the assets directly.
- It may reduce the tax rate gap between dividends and capital gains, which may lead to a reduction in the use of capital gains stripping transactions that involve generating personal income from a corporation at capital gains rates versus dividend rates.
- Capital losses will reduce capital gains at the same inclusion rate of the capital gain. Tax-loss selling to realize capital losses when capital gains are over $250,000 will fully offset such gains. Capital losses from other years may be more valuable when used to reduce capital gains included at the higher two-thirds rate.
- For corporations, capital gains will increase their Adjusted Aggregate Investment Income (AAII) more quickly. For example, a total capital gain of $74,627 will create $50,000 of AAII at a two-thirds inclusion rate; previously, a $100,000 total capital gain was needed. The small business deduction (SBD) is reduced by $5 for every $1 of AAII starting at $50,000. Conversely, current year capital losses, which reduce AAII, are more valuable at a two-thirds inclusion rate.
- It may create an incentive to trigger capital gains before June 25, 2024.
- It may result in revisiting the investment mix between personal and corporate portfolios to take advantage of the one-half capital gains inclusion rate on the first $250,000 for individuals.
- There may be more incentive to have corporations gift publicly traded securities and segregated fund contracts to charity, thereby increasing the CDA credit and avoiding the two-thirds capital gains inclusion rate.
- There may be more incentive to move corporate dollars into the tax-free environment of an exempt life insurance policy.
Overall, no draft legislation has been provided and the Department of Finance has indicated that additional details are coming.
Lifetime capital gains exemption increases
The LCGE is a tax exemption for capital gains realized on the disposition of qualified small business corporation shares and qualified farm or fishing property. The LCGE is currently $1,016,836 in 2024, indexed to inflation. Budget 2024 proposes to increase the LCGE to apply up to $1.25 million of eligible capital gains. This measure would apply to dispositions that occur on or after June 25, 2024. Indexation of the LCGE would resume in 2026.
Canadian Entrepreneurs’ Incentive
Budget 2024 proposes to introduce the CEI to dispositions of shares that occur on or after January 1, 2025.
This is an incentive that would result in a reduced tax rate on capital gains on the disposition of qualifying shares by an eligible individual by reducing the capital gains inclusion rate to one-half of the prevailing inclusion rate, on up to $2 million in capital gains per individual over their lifetime. This measure would apply in addition to the LCGE.
The lifetime limit is scheduled to be phased in by increments of $200,000 per year, beginning on January 1, 2025, before ultimately reaching a value of $2 million by January 1, 2034.
Under the two-thirds capital gains inclusion rate proposed in Budget 2024, this measure would result in an inclusion rate of one-third for qualifying dispositions.
Tests to qualify are similar to those for the LCGE, including:
- The small business corporation requirement at the time of sale (i.e., the 90 per cent rule),
- The 24-month holding period requirement as a Canadian Controlled Private Corporation (CCPC),
- That more than 50 per cent of the fair market value (FMV) of the assets of the corporation were used principally in an active business carried on primarily in Canada by the CCPC or by a related corporation.
In order to qualify, additional requirements include that the claimant be a founding investor who held the share for a minimum of five years prior to disposition and held more than 10 per cent of the FMV of the issued and outstanding capital stock of the corporation and at least 10 per cent of the votes. The claimant must also be actively engaged on a regular, continuous, and substantial basis.
Finally, there’s a restriction that the corporation can’t be a professional corporation or a corporation that carries on certain types of businesses, including operating in the financial, insurance, real estate, food and accommodation, arts, recreation, or entertainment sector or providing consulting or personal care services.
Employee ownership trusts
The Employee ownership trust (EOT) was first introduced in the 2023 federal budget, and the 2023 Fall Economic Statement proposed to exempt the first $10 million in capital gains realized on the sale of a business to an EOT from taxation, subject to certain conditions. Budget 2024 articulates the qualifying conditions, including those around who the seller can be, what a qualifying transaction is, conditions that are applicable 24 months prior to the sale, a requirement to be actively engaged in the business, and a requirement that at least 90 per cent of the beneficiaries of the EOT be a resident of Canada. The budget also indicated that where there are multiple individuals disposing of shares to an EOT, the $10 million exemption must be shared among them.
Budget 2024 also identifies the idea of a disqualifying event. A disqualifying event would occur if the EOT loses its status, or less than 50 per cent of the FMV of the assets are being used principally in an active business at the beginning of two consecutive taxation years of the corporation. Where a disqualifying event occurs within 36 months of the qualifying business transfer, the exemption wouldn’t be available. Where the individual has already claimed the exemption, it would be retroactively denied. If the disqualifying event occurs more than 36 months after a qualifying business transfer, the EOT would be deemed to realize a capital gain equal to the total amount of exempt capital gains.
Additionally, for an individual to claim the exemption on a sale to the EOT, the EOT, individual, and the corporation owned by the EOT would need to be jointly and severally liable for any tax owing by the individual in the event of a disqualifying event.
Capital gains exempted through this measure would be subject to an inclusion rate of 30 per cent for the purposes of an alternative minimum tax (AMT), similar to the treatment for gains eligible for the LCGE.
These measures would come into force for qualifying dispositions between January 1, 2024, and December 31, 2026.
Alternative minimum tax
The AMT is a parallel tax calculation allowing for fewer tax credits, deductions, and exemptions than under the ordinary personal income tax rules. Taxpayers pay either regular tax or AMT, whichever is highest. There was an iteration of the draft rules created in the summer of 2023 which were published for consultation. Budget 2024 proposes that the tax treatment of charitable donations be revised to allow individuals to claim 80 per cent (instead of the previously proposed 50 per cent) of the charitable donation tax credit when calculating AMT. Except for EOTs which are fully exempt, the budget didn’t provide any further relief to trusts, which continue to not have a basic exemption.
AMT should be a consideration when determining whether someone should trigger capital gains before June 25, 2024 to benefit from the one-half capital gains inclusion rate, as it may lead to additional cash taxes owing.
We are already into AMT rules as these amendments would apply to taxation years that begin on or after January 1, 2024.
Overall
More details and analysis are required, especially regarding changes to the capital gains inclusion rate and other related changes that didn’t have draft legislation. But life insurance continues to be a good option to grow tax-deferred value, CDA creation and the liquidity it ultimately provides on the death of the insured, which will be more powerful in a higher capital gains tax rate environment.
