With the federal budget expected in April 2021 (the first one in over two years!), many advisors, along with our clients, have been speculating as to whether capital gains taxes could be on the government’s agenda, given the massive COVID-19 relief spending of the past twelve months. Let’s take a look at who could be affected by a change in rates, as well as some potential planning that can be done if your clients fear an increase in the inclusion rate may be imminent.
The capital gains tax, of course, is only a concern if clients hold appreciated investments in a non-registered account. Under Canadian tax law, only 50% of capital gains are taxable, at your marginal rate. Depending on your province of residence, for high-income earners, the marginal tax rate on capital gains in 2021 can be as high as 27%.
And, as it turns out, high-income earners pay the majority of capital gains tax. The latest income tax statistics (from 2017) show that only about 10% of the 28.5 million personal tax returns filed that year reported any taxable capital gains. And of the $37 billion in aggregate taxable capital gains reported, over three-quarters of the gains (almost $30 billion) were earned by the 10% of taxpayers with income over $100,000 who reported capital gains (roughly 760,000 filers), while 55% ($20 billion) of the total gains were realized by the 1% of taxpayers with income over $250,000 who reported capital gains (about 160,000 filers).
Planning for a potential increase in the capital gains inclusion rate
If you’re among those advisors who fear that the government may, indeed, increase the inclusion rate, what can you do about it now? The easy thing to do is simply to encourage your clients to sell their appreciated assets and lock in their capital gains tax bill at the current 50% inclusion rate. But if it doesn’t make sense to sell an asset prior to a potential tax-rate increase, the fear of such an increase shouldn’t change your investment decision. As we often say, “Don’t let the tax tail wag the investment dog.”
It may be possible for clients to have their cake and eat it too, albeit with some additional tax-planning complexity and compliance costs.
The basic strategy for appreciated securities is to sell the securities to a Canadian holding company (either new or existing) in exchange for shares with a fair market value (FMV) equal to the FMV of the securities being sold. This must be done prior to any increase in the capital gains inclusion rate.
If the capital gains inclusion rate increases in a spring 2021 budget, the client does not need to do anything more. The transfer will be reported on the 2021 income tax return as a taxable transaction that triggered a capital gain at the current 50% inclusion rate. The cost of the securities to the holding company will be the securities’ FMV.
If, on the other hand, the capital gains inclusion rate does not increase, the client and corporation can jointly file a “section 85” rollover election and elect that the securities be transferred for tax purposes at their adjusted cost base (“ACB” or tax cost), so that no gain was realized. The cost of the securities to the holding company will be the elected amount (that is, their ACB).
But, since triggering capital gains by transferring the securities at FMV involves paying the tax today (albeit at the lower inclusion rate), it may not make sense if the client isn’t contemplating a sale of the securities in the near future. That’s because taxes would be paid earlier than they otherwise would be and, thus, the time value of money would need to be considered in determining whether this strategy makes sense. In addition, the client would now own their investment portfolio through a corporation, which adds a layer of complexity that they simply may not want. Annual corporate tax returns would need to be filed for the corporation and, if they want to take investment income out of the holding company, the corporation would have to declare dividends, which involves directors’ resolutions and the filing of T5 information tax slips.
Clients contemplating such a strategy should be sure to speak to their tax and legal advisors before executing this strategy.