There are always predictions about what tax changes will be included in the federal government’s annual budget. Like many times in the last several years, there is speculation that the capital gains inclusion rate will increase from 50% to 75%. This concern has gained renewed traction in the current year, due to the current Liberal minority government, which will require another political party to support their budget. The most probable source of support would be the NDP, whose campaign platform included raising the capital gain inclusion rate to 75%. As a result, political concessions could be made that would result in this change being included in the budget.
No official comments or announcements have been made about this, and it is unknown whether the federal budget will bring in such a change. Nevertheless, there is a risk that if the change is brought in, it may be made effective immediately on the budget date. It may be beneficial to be aware of implications of this change, should it go into effect, and plan ahead.
No budget date has been announced as yet, but, it has historically occurred in February or March.
The following discussion is general in nature and professional advice should be obtained prior to implementing or executing any strategy.
What is the capital gains inclusion rate?
A capital gain arises when you sell a property for more than you bought it for. Conversely, a capital loss arises when the opposite occurs. Capital gains and losses are most commonly realized on real estate and investments.
When you report a capital gain on your income tax return, only a percentage of the gain is considered taxable, and the rest of that gain is tax-free. The percentage that is taxed is known as the capital gains inclusion rate. Since tax on capital gains was first introduced in 1972, the inclusion rate has changed several times, from a minimum of 50% to a maximum of 75%. The current rate is 50%.
If you have securities that have appreciated in value, you normally stand to realize a capital gain when you eventually dispose of them, and would have taxable income based on whatever inclusion rate is in effect on the date of disposal. Below are three possible strategies to mitigate the potential tax cost arising from any increase in the inclusion rate. For any of these strategies, you must consider their non-tax implications and their cost before deciding to implement them.
Rebalancing your portfolio
Schedule a review of your non-registered investment portfolio in advance of the budget date. If it is found that rebalancing the portfolio is appropriate for investment purposes, determine whether the rebalancing transactions would trigger either capital gains or capital losses. If you would realize capital gains, consider completing the transactions prior to the budget date.
Transfer to a holding company
Another strategy is to transfer securities that have appreciated in value to a holding corporation. With such a transaction, there is an election available that lets one choose to transfer the assets at a value somewhere between the adjusted cost base (ACB) and the fair market value (FMV).
The timing of this election creates the opportunity to implement the transfer prior to the budget date, wait and see whether the inclusion rate increase occurs, and then plan the election accordingly.
The implementation of this strategy would involve transferring the securities prior to the budget date. Then, if the budget does not increase the inclusion rate, prepare the election to transfer the securities at cost, not triggering any capital gain. Or, if the budget does increase the inclusion rate, elect to transfer them at fair market value, hence triggering a capital gain at the lower inclusion rate.
Among the main disadvantages of this strategy, it is generally not tax efficient to earn investment income in a holding corporation. New tax rules could also reduce access to the Small Business Deduction of any corporations associated with the holding company. If you do not already have a holding corporation, you would need to set one up, incurring the initial set-up costs and ongoing tax compliance costs for the corporation. Further, consideration needs to be given on the implications of how the holding corporation would factor into your estate plan.
Transfer to your spouse or common-law partner
Similar to the previous strategy, you may transfer appreciated securities to your spouse and later choose whether to file an election to report the transfer amount at fair market value. The main advantage is again that you have the option of triggering capital gains at the lower inclusion rate, or not triggering capital gains at all if the inclusion rate does not change.
To implement this strategy, the transfer needs to be made prior to the budget date. The default tax effect is that the transfer is considered to occur at the adjusted cost base. However, if the inclusion rate increase comes into effect after the budget date, you may then file an election to recognize the transaction at fair market value. The deadline for the election is the same as for your income tax returns for the year in which the transfer occurred. The effect would be triggering capital gains in your hands at the lower inclusion rate.
If the transfer is made at cost, then future income or capital gains from the securities would still flow to your own return. If the transfer is at fair value the future income and capital gains could be taxed in your spouse’s hands if they provide adequate consideration at the time of the transfer, such as cash or an interest-bearing loan.
The main concerns with this strategy are its potential impact on your estate plans and the impact it would have on family law matters.
In each of the above strategies, in the event of an inclusion rate increase you would be intentionally triggering a capital gain. This creates an upfront tax payable, loss of tax deferral, and potentially increased tax installments in the following year. On the other hand, if your capital gains would be significant, you may save significant tax down the road.
Until budget day itself, we will not know for certain what the coming budget will hold in terms of the capital gains inclusion rate. The above discussion provides some ideas for managing the risk that it might increase. You should speak to us to see if a higher inclusion rate might have a significant tax impact for your situation, and if one of above strategies are appropriate for you.
This publication is a general discussion of certain tax matters and should not be relied upon as professional advice. If you require tax advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.