The Capital Gains Tax Rate and its Impact on Estate Planning

There has been much discussion in recent years about whether the capital gains inclusion rate might be increased, with these discussions intensifying whenever we approach a federal Budget.  Currently, ½ of capital gains are subject to tax, with the other half being tax-free – this translates to a maximum effective tax rate of 26.77% on capital gains for individuals resident in Ontario (25.1% for corporations).  If the capital gains inclusion rate were to increase to ¾, this would effectively increase the tax rate on capital gains to 40.15% for individuals and 37.63% for corporations – a 50% increase in the tax rate.

Much of the discussion around the capital gains inclusion rate is generally focused on planning to trigger capital gains prior to any change in the inclusion rate and there are various ways that this can be accomplished, depending on the facts.  The idea is that it may be better to pay tax now (at the current 26.77% rate), rather than at some point in the future at a higher rate (of potentially 40.15%).  The timing of when this capital gain might otherwise have been realized is an important factor in this consideration.  In other words, if the asset in question will not be sold for 15 years for example, one would actually be better off paying the higher rate of tax down the road (and having an extra 26.77% of the current value invested over that period).  One situation where one would typically not want to trigger capital gains prematurely is where an “estate freeze” has been implemented.

An estate freeze is a strategy whereby an individual may “freeze” the value of their direct ownership in assets, such that the individual ends up owning fixed-value Preferred shares of a holding company.  As an example, if an you own an investment portfolio with an unrealized gain of $5 million, the investments could be transferred on a tax-deferred basis to a holding company in exchange for Preferred shares of the holding company with a fixed value of $5 million.  To the extent that the value of the underlying investments increases over time, that increased value may only be taxed in the next generation’s lifetime.  In this case, you would know with certainty that you will never pay more than $1.3 million in tax on the holding company Preferred shares that you own if held them until death.  Or maybe not.

If the capital gains inclusion rate were to increase to ¾, this individual may face a tax liability upon death of over $2 million instead, despite having implemented the planning when tax rates were lower.  This may be a significant issue where the underlying assets are illiquid, such as real estate or a business.  Even where the underlying assets a liquid, an increase in the tax rate could still throw a wrench in the planning previously undertaken, particularly if a portion of the estate was to be earmarked for specific uses (such a charitable giving, or if specific amounts were intended to be left to beneficiaries).  While a person may have planned their estate based on the rules and tax rates in place at the time, increasing the capital gains inclusion rate would be akin to changing the rules of a game part way through.

Regardless of whether we see a change in the next federal Budget or some time in the future, there appear to be many reasons that the government will want to increase this at some point.  For anyone who has implemented an estate freeze previously, they will want to revisit their plans to determine what impact any tax increase might have on their estate plans and how they might be able to manage an increased tax liability.  Where life insurance has been purchased to fund this tax liability, you will want to consider whether the coverage continues to be sufficient, whether additional life insurance may be required, or whether additional life insurance is even an option.  This may also mean re-evaluating your plans for distributing your estate.  Speak to your Welch LLP advisor to help guide you through this process.

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