In More Ways Than You Think
The federal Budget was presented on April 16, 2024 and among a number of proposed tax changes, included an increase in the capital gains inclusion rate from ½ to 2/3 for corporations, as well as for individuals in respect of any capital gains in excess of $250,000 in a given year. This change is to apply for capital gains realized after June 24, 2024 and will effectively increase the tax rate applicable to capital gains realized by corporations to 33.45% (from the current 25.1%) and to 35.69% for affected individuals (from the current 26.77%). However, in addition to directly increasing the tax rate, this change will have many other indirect implications for taxpayers, as discussed below.
Triggering capital gains – while triggering capital gains before this increase may result in less tax, consideration should be given to whether you would be better off paying a lower tax rate now, but having less value invested over a period of time. Factors to consider would include when the assets might otherwise have been sold, and what the expected rate of return might have been over that period.
Cost of earning investment income in a corporation – Canada’s tax system is intended to integrate the personal and corporate tax regimes in a way that taxpayers should be indifferent as to whether they earn income personally and pay personal tax, or earn income in a corporation and pay corporate tax, then distribute the corporate funds as a dividend and pay personal tax. However, there has always been a tax cost to earning investment income through a corporation – 4.4% for interest and rental income, 10.4% for foreign dividends and until recently, 2.2% for capital gains. However, in the case of individuals that would have less than $250,000 of capital gains personally, the cost of earning capital gains through a corporation will now increase to 11.86%. There will continue to be reasons for using corporations to earn investment income, including to achieve a significant tax deferral where the invested capital is generated from an active business, and for estate planning reasons. However, this increased tax cost for capital gains will have to be considered, along with whether certain types of income should be earned outside of the corporation if possible.
Terminal tax liability – an “estate freeze” is a common estate planning strategy where assets are held in a corporation and the individual owns fixed-value Preferred shares of the corporation, thereby limiting the tax arising on death based on the value of the Preferred shares owned (Common shares of the corporation are owned directly or indirectly by family members, such that tax attributable to the future growth in value may be deferred to the next generation). By capping one’s maximum tax liability, this strategy provides some certainty over the amount of tax that may be payable on death and facilitates plans to fund this tax liability. However, the increase in the capital gains inclusion rate effectively increases what one may have thought was their maximum terminal tax liability by 1/3. Consideration should now be given to how one’s estate will fund this additional unexpected liability, particularly in the case of illiquid estates that own significant real estate or private company shares. Life insurance may be one option for funding this amount, if additional life insurance can be obtained at a reasonable rate at this point.
Small business deduction – an associated group of Canadian-controlled private corporations is entitled to a lower corporate tax rate (12.2% in Ontario) on the first $500,000 of active business income (compared to 26.5% otherwise). Where the group’s aggregate investment income in a year exceeds $50,000, its entitlement to this lower tax rate will be clawed back in the following tax year. Where aggregate investment income exceeds $150,000, the group will not be entitled to this lower tax rate in the following year. The increased capital gains inclusion rate will increase corporate groups’ taxable capital gains, thereby increasing investment income and reducing the group’s entitlement to this lower tax rate.
Stock options – employers may use employee stock option plans as a tool to attract and retain employees, while preserving cash. Many employees find stock option compensation attractive because the benefit may be reduced by half, mirroring the tax result of a capital gain. In order to maintain this parity with capital gains treatment, the Budget proposes to reduce this employee stock option deduction from ½ to 1/3 for any portion of the stock option benefit exceeding $250,000 in the year (note that the individual’s capital gains for the year would also be taken into account in this $250,000 threshold). This change will make stock option compensation less attractive for some employees, while employers may need to find alternate means of compensating employees.
Capital gains exemption – the lifetime capital gains exemption currently allows individuals to realize tax-free capital gains from the disposal of qualified small business corporation shares and qualified farm or fishing property during their lifetimes. The exemption will increase to $1,250,000 (from the current $1,016,836) beginning on June 25, 2024. Between the increase in the capital gain exemption threshold and the increased capital gains inclusion rate, the lifetime capital gains exemption will provide significantly more tax savings – up to $446,000 per exemption, compared to $272,000 currently. To the extent the corporate structure allows family members to participate in ownership, these savings can be significant. Business owners will want to ensure that their corporate structures are optimal for purposes of accessing the maximum benefits from the lifetime capital gains exemption.
As you can see, the adjustment of the capital gains inclusion rate on its own has many direct and indirect implications for all taxpayers, particularly for business owners. Contact your Welch LLP advisor to discuss how these changes impact your situation.
