Budget 2024 proposes to significantly change how capital gains are taxed under the Income Tax Act (Canada) (the "Tax Act"). The proposed increase in the effective tax rate applicable to capital gains will have broad reaching effects (potentially broader than articulated in the Budget materials presented by the federal Minister of Finance). The draft proposals raise a number of unanswered questions and present taxpayers with an opportunity to consider whether any steps should be taken in advance of the June 25, 2024 effective date of the proposed changes, as well as what steps should be taken in the future to mitigate the adverse effects of the proposals.
Proposed Legislative Changes
Currently, one-half of most capital gains are included in computing a taxpayer's income under the Tax Act. This mechanic generally results in capital gains being taxed at one-half the rate of ordinary income. Budget 2024 proposes to increase the inclusion rate from one-half to two-thirds for corporations and trusts and, in the case of individuals, on the portion of capital gains realized in a year that exceeds $250,000.
The Budget proposals contemplate that the $250,000 capital gains threshold will generally be computed net of certain targeted tax amounts including (i) current-year capital losses, (ii) capital losses carried forward from earlier years or carried back from subsequent taxation years, and (iii) capital gains in respect of which the taxpayer has claimed the Lifetime Capital Gains Exemption, the proposed Employee Ownership Trust Exemption, or the proposed Canadian Entrepreneurs' Incentive.
The proposed rules contemplate that net capital losses realized by a taxpayer at a time when the one-half inclusion rate was in effect may be applied against capital gains realized at a time when the two-thirds inclusion rate is in effect (such that capital losses realized prior to the rate change would fully offset equivalent capital gains after the change).
Budget 2024 proposes certain ancillary changes to the stock option deduction rules to preserve the approximate equivalency of the inclusion rate for employee stock options qualifying for the stock option deduction and gains realized by an individual on capital account. To maintain the approximate equivalency of these regimes, a claimant eligible to claim the employee stock option deduction will continue to be eligible for a one-half deduction up to a combined limit of $250,000 for both employee stock options and capital gains, with the available deduction under the employee stock option deduction regime reduced to one-third beyond such limit.
Budget 2024 proposes that the new capital gains regime apply in respect of capital gains realized on or after June 25, 2024. Transitional rules are proposed for taxpayers with taxation years commencing before and ending on or after June 25, 2024. Such taxpayers will separately track capital gains and losses realized before June 25, 2024 (where the rules relating to the two-thirds inclusion will not apply) and capital gains and losses realized on or after June 25, 2024 (the period during which the new rules would apply). Capital losses realized in the first period may be applied against capital gains realized in the latter period. Notably, the $250,000 threshold for individuals is not proposed to be pro-rated for 2024, such that the full $250,000 limit will apply to gains realized after June 25, 2024.
The Budget materials did not include draft implementing legislation for the capital gains inclusion rate proposals and instead indicated that additional design details would be released in the coming months. Accordingly, there remains much uncertainty about the application of these rules.
Observations / Questions
We have set out certain observations/questions below in respect of Budget 2024's capital gains inclusion rate proposals:
- Canada's tax system has traditionally had "integration" as one of its guiding principles – the idea that the tax system should not incentivize or disincentivize use of a particular business vehicle, instead attempting to tax fully distributed income on an approximately equal basis, regardless of the business vehicle selected. For this reason, the combined level of corporate tax and dividend level taxation of business income earned through a corporation has traditionally been approximately equivalent to the taxation imposed on the income of an unincorporated sole proprietor.
The Budget proposals will materially disrupt the principal of integration in circumstances where a holding corporation is being used as an investment vehicle. Such holding corporations would not be eligible for the $250,000 exemption on capital gains available to individuals, even though a holding corporation might be closely held by an individual and/or the individual's close family members. Such an outcome might consequently discourage the use of holding corporations as investment vehicles.
- The Budget 2024 proposals do not draw any distinction between capital gains realized by a resident of Canada for purposes of the Tax Act and capital gains realized by a non-resident of Canada. It is anticipated that the withholding tax rate on dispositions by non-residents of "taxable Canadian property" (as defined for purposes of the Tax Act) may be amended to reflect such higher rates, creating additional potential exposure for purchasers that fail to duly withhold and remit.
- Budget 2024 estimates that the federal government will derive approximately $19.4 billion of additional tax revenue over the coming five years from the capital gains inclusion rate changes. The Budget documents further estimate that the provinces and territories of Canada could derive up to $11.6 billion of additional tax revenue as a consequence of the proposed amendments (presumably assuming that any necessary amendments to provincial law, notably in the Province of Quebec, are passed to mimic the federal amendments). Interestingly, the Budget projections suggest that the proposals will raise $6.9 billion for the federal government in the 2024-25 fiscal year, with the funds raised by the measure reducing over the subsequent years. This implies that the Government expects a material number of taxpayers to accelerate the recognition of accrued capital gains prior to the June 25, 2024 implementation date.
- The Budget materials did not specify whether the $250,000 exemption for individuals from the elevated two-thirds inclusion rate will be adjusted for inflation on an annual basis (as are various other threshold amounts in the Tax Act) or whether the application of the two-thirds inclusion rate will gradually broaden over time as the real value of the $250,000 exemption is eroded away through inflation.
- The attractiveness of flow-through shares will need to be re-evaluated in light of the proposed amendments to the capital gains inclusion regime. Flow-through shares are tax-favoured securities issued by certain corporations engaged in qualifying mining exploration and similar activity. Issuing companies engaged in such arrangements are generally able to renounce certain unused tax deductions to shareholders who can claim such deductions when computing their taxable income. However, as a holder of such shares is generally deemed to have an "adjusted cost base" of nil in such securities, there is typically a capital gain recognized on the sale of the shares after the tax attributes have been renounced to the shareholder. The elevated inclusion rate on capital gains may make such arrangements less attractive.
- Taxpayers that donate publicly listed shares and certain other assets to registered charities under the Tax Act are generally exempt from capital gains tax on any accrued gain realized on the donation of such property. The increased inclusion rate applicable to capital gains realized on or after June 25, 2024 means that the tax savings attributable to such gifting arrangements could become more valuable following the effective date.
- The Budget cites figures indicating that only a small percentage of taxpayers will be subject to the increased capital gains inclusion rate (0.13% of individual Canadians and 12.6% of corporations) and observes that such taxpayers represent some of the wealthiest Canadians. However, we note that the proposals have the potential to impact a significantly broader number of persons. For example, a taxpayer selling a family cottage/cabin for a significant gain may, by virtue of the realized capital gain, record significant taxable income in the year of disposition, thereby falling within the ambit of the proposed rules. Similarly, the Tax Act deems a person to dispose of all of his/her assets at fair market value immediately before death, which could cause many middle-income taxpayers to record a significant capital gain in the taxation year ending immediately before their death and, consequently, becoming subject to the two-thirds capital gains inclusion regime.
Mitigation
Taxpayers should carefully consider whether there are any mitigating steps that should be taken before the June 25, 2024 effective date of the capital gains inclusion proposals. In addition, taxpayers will need to assess whether common operating procedures and policies should be re-evaluated for future years in light of such amendments. We note the following strategies and procedures may need to be re-evaluated in light of the proposed capital gains inclusion regime:
- As noted above, the proposed two-thirds capital gains inclusion rate only applies to capital gains realized on or after June 25, 2024. Accordingly, certain taxpayers currently in the process of selling a capital asset may wish to accelerate their transaction timelines to ensure the sale closes before June 25, 2024. Where this is not feasible, taxpayers may consider engaging in certain reorganization transactions to crystalize a capital gain before June 25, 2024.
- Under the current rules, it is customary for a taxpayer realizing a capital loss to "carryback" such loss to one of the three prior taxation years, subject to the detailed rules in the Tax Act, in order to realize a cash tax saving. However, taxpayers may wish to reconsider this strategy over the next few years because, under certain circumstances, tax losses may be more valuable if applied against capital gains realized in tax periods when the two-thirds inclusion rate applies, rather than carrying them back to periods when the one-half inclusion rate applied.
- The Tax Act currently permits a taxpayer in certain circumstances to claim a reserve in respect of proceeds from a disposition of capital property that have not yet been received. Claiming such a reserve could allow a taxpayer to spread the taxation of a capital gain over as many as five taxation years. It may be advantageous for individuals to structure their affairs in a manner that the capital gain reserve may be claimed to maximize the number of years over which the benefits of the $250,000 one-half inclusion rate may be claimed. Similarly, individual taxpayers may wish to strategically realize capital gains in particular taxation years in order to monetize the full amount of the reduced one-half inclusion rate on the first $250,000 of capital gains realized in the year (effectively accelerating the payment of tax in favour of paying tax at a reduced rate).
- Taxpayers will need to consider whether a holding corporation remains the desired vehicle to hold certain capital assets. Since the Budget proposals contemplate that corporations will be subject to the two-thirds capital gains inclusion rate on all gains, and not just those above $250,000 as is the case with individuals, it may no longer make sense to hold certain capital assets in a corporation. Alternatives to consider may include some combination of limited partnerships, trusts (assuming all of the income is flowed out of the trust to its beneficiaries) or direct personal holdings of capital assets.
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Since Budget 2024 did not include draft legislation implementing the proposed two-thirds capital gains inclusion rate, there remains much uncertainty about the application of the new rules. New concerns, strategies and observations are expected to arise as more is learned about the proposals. McMillan will continue to monitor these developments closely.
The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.
© McMillan LLP 2024