May 03, 2024

The Capital Gains Conundrum

The 2024 Federal budget announced on April 16th has caused significant turmoil for investors, cottage owners and their accountants. The proposed increase to the capital gains inclusion rate to 66 and 2/3% has everyone working overtime (in the middle of an already busy tax season) trying to figure out what to recommend to clients in light of the proposed change.

A short history

Placing changes in historical context can help gain perspective. Canada first introduced the tax on capital gains in 1972, ten years after Diefenbaker appointed a Royal Commission on Taxation, known as the Carter Commission. Carter’s famous quote “A buck is a buck is a buck” neatly summarized the recommendation to start taxing capital gains, arguing that regardless of the form, income from all sources should be taxed. The implementation of the capital gains tax also followed the abolition of the estate tax in Canada, on the argument that a tax on capital gains would be a fairer and more consistent way to tax wealth transfers than the prior estate tax regime.

The Carter Commission originally recommended a tax on the entirety of any capital gains at the tax payor’s marginal tax rate, but Pierre Trudeau’s government only implemented a tax on half of capital gains realized. This 50% inclusion rate carried on until Brian Mulroney’s administration increased it to 66 and 2/3% in 1988 and again to 75% in 1990. However, under Chrétien and Finance Minister Paul Martin, the inclusion rate was reduced back down to 50% over the course of the year 2000, arguing that lower taxes on capital would incent stronger business investment. So, for the 52 years that Canada has had a capital gains tax, 40 of those years have been at 50% inclusion, 10 of them at 75% and only 2 (and counting) at 66 and 2/3%. For a deeper history of the capital gains tax in Canada, I highly recommend this article from 2021 by a Catherine Brayley of Miller Thompson LLP.

What should I do?

All Canadians now face a challenging decision: Should I crystalize my capital gains now, at the 50% inclusion rate in effect until June 25th, 2024, or should I continue to defer the realization of the gain on my personal portfolio, holding company portfolio, or cottage until a later date, despite the higher inclusion rate in the future?

For personal investments and cottages the new rules will allow the first $250,000 of capital gains realized per year to continue to be taxed at the lower 50% inclusion rate. Gains above $250,000 in any given year will be taxed at the new, higher inclusion rate. As a result, the top effective tax rate on capital gains over $250,000 goes from 26.7% to about 35.7% in Quebec and Ontario.

For corporations and trusts, there will be no $250,000 threshold like for personal gains. Every dollar of capital gain in a corporation or trust will be included in income at the new 66 and 2/3% inclusion rate.

We’ve been busy modeling the impact of these new inclusion rates, and more specifically the question of whether it is better to trigger capital gains now at lower rates or defer them into the future at higher rates.

Of all the variables we tested, the conclusion boils down to this: If you are already in the highest income tax brackets before including your capital gains, it takes about 8 years to break even. In other words, not triggering gains and taxes today and therefore keeping more dollars to invest will be worth more to you than the cost of the higher inclusion rate after about 8 years have passed. Alternatively, if you expect to liquidate your investments within the next 8 years, you should consider crystalizing the gains now at the lower inclusion rate. If your income (prior to including capital gains) is in lower income tax brackets, the break-even can stretch out to as many as 12 or 13 years.

Don’t rush the decision

The above conclusions only consider the quantitative, but it is also worth considering the political risk inherent in the decision. The Liberal government just separated the capital gains provision of the budget into its own bill, separate from the rest of the budget implementation bill. Does that bill risk being voted down? Would a future government potentially reverse the increase in the inclusion rate? Unfortunately, the answers to these questions are unknowable today.

Most of our clients are better not doing anything and benefitting from the continued deferral of taxes until later in their investment lives. For instance, if the total unrealized gains on your personal non-registered accounts are below $250,000, then the new rules are a moot point. However, we are busy reviewing all client situations to identify those that might benefit from triggering gains before the June 25th deadline. As we work through these scenarios, we will be reaching out to discuss the relevant strategies to all concerned.

In the meantime, if you have any significant needs from your portfolio in the near term that risk triggering significant gains, feel free to reach out to us to discuss what your best options are.

Peter Guay
Peter Guay

Peter joined PWL Capital in 2004 and learned the firm’s client-first philosophy from the ground up. Eighteen years and many designations later, he is now a seasoned Portfolio Manager and Financial Planner working with families across the country.

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