priority / Nuthawut Somsuk

The recent budget proposals regarding capital gains have upended the retirement and estate plans of many affluent Canadians. For nearly a quarter of a century, the capital gains tax has been based on a 50% inclusion rate, significantly reducing the tax payable on realized capital gains compared to foreign dividends, interest and other income. Although eligible dividends are more tax advantaged for many Canadians due to the gross-up and dividend tax credit mechanism, realized capital gains were the lowest taxed income for those at higher marginal rates.

This hierarchy has been swept away by the budget proposals to increase the capital gains inclusion rate to two-thirds from one-half for capital gains realized annually that exceed $250,000 for individuals and for all capital gains earned in corporations and trusts. The new inclusion rates will be effective for gains realized on or after June 25.

The change increases the overall capital gains tax at the highest marginal rate to levels in the range of tax on eligible dividends, though the level varies by province. In fact, in six provinces, the combined corporate and personal tax from distributing both the taxable and non-taxable portion of capital gains from a corporation will exceed that of eligible dividends for those at the highest marginal rate.

The delay in implementation to June 25 provides a window of opportunity for advisors to adjust their clients’ portfolios to mitigate the damage from this rate hike. Here are seven actions for advisors to take.

1. Determine which clients need to act before June 25. Clients affected on an ongoing basis are corporations and trusts, and individual clients who normally realize capital gains of more than $250,000 annually. Individuals planning major disbursements in the next several years (e.g., gifts to children, a vacation home purchase) may also be affected.

Clients in special situations with possible capital gains implications need to be identified. These include individuals with massive unrealized gains who may not normally have annual capital gains more than $250,000, particularly if they have concentrated positions; clients planning major charitable donations with appreciated securities; individuals with a material change expected in their tax rates in coming years versus 2024; clients considering a major change in their strategies; individuals planning to depart Canada; or clients with a limited life expectancy. These clients will need to have their situations analyzed.

2. Review the cash-flow needs, income and capital sources, and tax characteristics of affected clients to quantify the capital gains that could be triggered to fund shortfalls tax-efficiently. For example, a professional who has routinely relied on capital dividends from their corporation to fund a sizable portion of their lifestyle spending likely has greater need to trigger capital gains before June 25 than a professional who funds their personal spending from a combination of salary and income from personal investments.

3. Re-evaluate the tax efficiency of the investments in client portfolios from a capital gains perspective. For affected clients, the tax drag associated with funds that generate elevated, recurring capital gains (e.g., a high-turnover fund with significant trading of appreciated securities) will jump significantly on June 25. As replacements, consider well-diversified, low-cost ETFs and funds with similar expected returns but that generate minimal capital gains.

4. Complete a “defer or sell” analysis of the appreciated holdings of affected clients. Selling an appreciated investment before June 25 results in a pre-payment of tax (though it avoids higher capital gains tax later if the new inclusion rate remains unchanged in subsequent federal budgets). You will therefore need to measure the long-term value of deferring taxes against the benefit of realizing gains now at a lower rate. Generally, the higher the forecast return, the longer the expected holding period, the greater the unrealized gain and/or the more tax-efficient the investment, the greater the likelihood that holding the investment for long-term deferral is the better option. A pre-liquidation, post-tax break-even analysis is the simplest comparison methodology.

5. Develop a plan to discuss with each client. Each client’s cash flow, income and tax profile in conjunction with the investment tax efficiency and “defer or sell” analysis will allow you to develop a disposition and repositioning plan tailored to that client. For example, clients relying on regular distributions from their corporations may now benefit from more exposure to investments that generate high eligible dividends. Sound portfolio construction, rebalancing and risk management remain fundamental to this plan.

6. Mind the traps. The new alternative minimum tax rules may apply to individuals in situations when substantial capital gains are realized. In addition, generating capital gains in a small business corporation with active business income may result in higher taxes due to the reduction in the small business deduction when adjusted aggregate investment income is above $50,000. Finally, distributing capital out of a corporation for reinvestment to access the $250,000 annual threshold as an individual can have material tax costs and probate tax implications as well as possible U.S. estate tax ramifications.

7. Liaise with the client’s accountants and other professionals. The tax impact of any major recommended changes should be reviewed with the client’s accountant or other professionals as needed.

Although the government has indicated the changes to the capital gain inclusion rules will proceed, the enabling legislation has yet to be enacted. As there continues to be uncertainty about many details of the proposed rules, you may wish to defer triggering material capital gains until mid-June, if feasible.

Michael Nairne, RFP, CFP, CFA, is president and CIO of Tacita Capital Inc., a private family office, and manager for TCI Premia Portfolio Solutions. 

An earlier version of this column stated an implementation date of July 25, which is incorrect. We regret the error.