As we have previously reported in our update on the 2024 Federal Budget ("Budget 2024"), the Department of Finance announced a proposed increase to the capital gains tax inclusion rate from 50% to 66 2/3% effective June 25, 2024, which generally increases the tax on capital gains realized on or after June 25, 2024 for an individual in the top tax bracket in Ontario from 26.76% to 35.69%. Despite significant public opposition, the Liberal Government remained resolute and introduced these measures in a Notice of Ways and Means Motion ("NWMM") on June 10, 2024, which was approved by the House of Commons on June 11, 2024. The NWMM is a precursor to an implementation bill, which is expected to be introduced in the fall of this year.
The Conservative Party of Canada voted against the NWWM but did not indicate whether they would reverse these rules if such rules were enacted, and the Conservatives are elected in 2025.
Assuming the proposed rules are enacted into law, this update explores various planning strategies to help mitigate the effects of the higher capital gains inclusion rate, focusing on tax deferral and minimization techniques.
Refresher Regarding the Proposed Rules
Prior to June 25, 2024, where a taxpayer realized a capital gain, only 50% of such gain was required to be included in income and subject to tax at the taxpayer's applicable tax rate. Budget 2024 proposes to increase the inclusion rate to 66 2/3% for dispositions occurring on or after June 25, 2024. For example, if an individual taxpayer realizes $100,000 of capital gains, the amount of the capital gain to be included in income increases from $50,000 to $66,666.
The proposed rules provide that the first $250,000 of net capital gains realized in a year is subject to the 50% inclusion rate (the "$250,000 half-rate exemption"), and any excess would be subject to the 66 2/3% inclusion rate.
Planning Strategies
1. Tax-Loss Utilization Structures
The utilization of tax losses in a corporate group will become more relevant with the increase in the capital gains tax inclusion rate. Prior to a sale or other disposition, a thorough examination of loss balances within corporate groups should be conducted to evaluate the benefits of a pre-closing reorganization that would enable the sale to occur through a loss company in order to shield anticipated capital gains realized on the sale.
2. Flow-Through Structures
Depending on the sector and the nature of the particular investment, clients should consider utilizing structures that would allow for flow-through treatment so that capital gains and losses could be realized directly by the individual taxpayer (who could then use their $250,000 half-rate exemption), or a trust (to multiply the use of the exemption, as described below). For example, individual real estate investors may hold their properties in single-purpose holding companies for liability protection. Under the proposed rules, on the disposition of such properties, the holding company would be subject to the higher capital gains tax inclusion rate without the benefit of the $250,000 half-rate exemption. In such situations, it may be prudent to utilize single-purpose limited partnerships to make such investments, which would provide the necessary liability protection but also allow for capital gains and losses to flow through to the individual investor. Flow through structures could also allow for the aggregation of losses from various sources to be applied against capital gains realized from a particular source.
3. Multiplication of the $250,000 Half-Rate Exemption
The use of family trusts to multiply the lifetime capital gains exemption ("LCGE") is a common planning technique used when shares of a corporation that meet certain criteria ("QSBC shares") are disposed of. On the disposition of QSBC shares, a vendor is entitled to an exemption from tax on a portion of the eligible capital gain. For dispositions on or after June 25, 2024, Budget 2024 proposes to increase the LCGE limit to $1.25 million. A common planning technique is to hold the qualifying shares through a family trust to multiply the LCGE between many different beneficiaries. When the trust disposes of the shares, it can choose to allocate the capital gains to the various beneficiaries to allow each of them to use their respective LCGE.
A similar technique could be used with ownership of capital assets where a trust with multiple beneficiaries would hold the property so that on the sale, tax could be minimized by allocating the capital gain to the beneficiaries and thereby multiplying the proceeds that would be subject to the $250,000 half-rate exemption.
4. Lifetime Capital Gains Exemption
Budget 2024 proposes to increase the LCGE to $1.25 million, which would be indexed for inflation annually beginning in 2026. With the increase in the capital gains tax inclusion rate, there should be a greater focus on determining if shares of a corporation could qualify as QSBC shares so that the sellers could claim the LCGE and shield some or all sale proceeds from tax. Moreover, choosing whether to accept a sale of shares or assets may become a greater point of negotiation between sellers and buyers and may give rise to more hybrid transactions (i.e., a transaction that involves both asset and share sales).
5. Deferral of Capital Gains
Individuals should also consider the utilization of estate freezes to defer tax to future generations. An estate freeze is a strategy used to limit tax liability on the death of a person and to transfer future appreciation of assets to their selected heirs. Under Canadian tax law, death generally results in a deemed disposition of the property of the deceased at the property's fair market value. Where a business is expected to increase in value, the business owner may wish to limit the gains that would be realizable on their death by "freezing" the value of their shares in the business at that particular point in time, thereby avoiding tax on any accrual in value from the time of the freeze to the time of their death. The future growth of the value of the business would be transferred to their children or other chosen heirs. For example, if shares of the business are worth $1 million at the time of the estate freeze but grow in value to $2 million at the time of the business owner's death, then assuming nominal cost base, the deceased business owner's estate would only realize a $1 million capital gain and the other $1 million would not be taxed until the holders of the growth shares dispose, or are deemed to have disposed, of the growth shares. There are several ways to implement estate freezes and it is possible to implement "reversible" estate freezes, which could be unwound in the future.
For real estate holdings that are expected to increase in value, it may also be possible to freeze the value of real property in the hands of an existing owner and to allow for future growth in value to accrue to chosen successors.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.