Financial advisors and their incorporated clients have mere weeks to decide whether to trigger billions in capital gains and adjust their long-term planning ahead of the feds’ proposed hike in the capital gains inclusion rate (CGIR) to two-thirds from half.
“We will eventually run out of time, and not everybody will be able to make their best choice,” said Alexandra Spinner, tax partner with Crowe Soberman LLP in Toronto. She will be meeting with clients this month to discuss next steps ahead of June 25, when the higher CGIR becomes effective.
One of Spinner’s clients will owe an additional $1.8 million in taxes on a sale of a corporately held asset, due to the higher CGIR. The asset must be sold after June 25 for regulatory reasons. “Sometimes you’re just stuck,” she said.
Joseph Bakish, portfolio manager and investment advisor with Richardson Wealth Ltd. in Pointe-Claire, Que., said he and his team are meeting with clients during the first half of May.
“We’re doing an entire evaluation of all our clients to see if an asset can be crystallized, and on what date, and then ask what the implications are overall for them,” said Bakish, who specializes in advising incorporated physicians. “Not all investors hold stocks and bonds that are liquid.”
On April 29, the Canada Revenue Agency issued an interpretation letter stating that selling a big chunk of assets prior to June 25 would not be considered tax avoidance.
“It is our view that where a taxpayer crystallizes an accrued capital gain prior to the increase in the CGIR, the [general anti-avoidance rule (GAAR)] would generally not apply,” the letter said. However, it cautioned that if the main purpose of the transaction is to obtain a tax benefit other than taxation of a gain at the current CGIR, GAAR may apply.
In the 2024 federal budget, the government proposed increasing the CGIR to two-thirds on capital gains realized in a year above $250,000 for individuals as of June 25. Currently, the CGIR is 50% for all capital gains realized by individuals. For corporations and trusts, the higher inclusion rate will apply to all capital gains realized on or after June 25.
The CGIR changes were not included in budget implementation bill C-69, which completed first reading on May 2, but the government has indicated the changes will go ahead.
Advising clients is difficult without the benefit of final legislation. For example, the government hasn’t indicated how capital losses from previous years may be allocated in 2024 before and after June 25, or whether the $250,000 threshold is indexed.
Bakish said he’s aiming for clients to trigger any capital gains around mid-June, hoping for greater clarity regarding the government’s proposals by then.
One thing that is clear is that generating capital gains on an individual basis will be even more tax-efficient after June 25 than doing so in a corporation if the changes are enacted as proposed.
In Ontario, for example, the tax rate for capital gains earned in a corporation and then distributed as dividends to individuals taxed at the top marginal rate will be 38.62% under the higher CGIR, up from 28.97% before June 25. That compares with 26.77% for individuals on the first $250,000 of gains and 35.69% above that threshold under the proposed changes.
The difference between tax rates on dividends and capital gains earned on investments held in a corporation will also narrow beginning June 25.
“Rather than triggering capital gains in the corporation, you may want to revisit your portfolio to make sure you’re triggering more capital gains at the personal level, because you have this $250,000 threshold,” said Hemal Balsara, head of tax, retirement and estate planning, individual insurance, with Manulife Financial Corp. in Toronto.
However, if a client triggers a significant capital gain personally before June 25, they could find themselves incurring the new alternative minimum tax (AMT) if, for example, the capital gain represents most of their income for the year. The AMT does not apply to income earned in a corporation.
Corporations may risk losing access to the small business tax rate more quickly under the proposed rules when generating capital gains. That’s because the small business deduction (SBD) maximum of $500,000 is gradually reduced when the corporation has aggregate investment income above $50,000 until the SBD is eliminated completely at $150,000.
With the CGIR at two-thirds rather than one-half, “aggregate investment income will grow faster due to more capital gains being included in the calculation,” wrote tax lawyers MaryAnne Loney and Michelle Fong with McLennan Ross LLP in Edmonton in a April 25 blog post regarding the proposed changes.
“Corporations will need to consider whether it makes more sense to pay amounts out to individuals, giving up the tax deferral, but allowing them to take advantage of the $250,000 threshold for personal capital gains and help allow their corporation to maintain access to the SBD,” they wrote.
Bakish said clients may look to draw more income from their corporation, despite the loss of deferral, to max out TFSAs and RRSPs and other tax-advantaged accounts.
Balsara said clients with enough money in their corporation to fund their lifestyle needs may consider corporately owned life insurance. Deposits grow tax-free within the policy, and the tax-free death benefit provides liquidity to fund tax liabilities. The difference between the death benefit and the policy’s adjusted cost basis can be distributed from the corporation’s capital dividend account as a tax-free dividend.
Effectively, “we’re re-characterizing retained earnings to tax-free capital dividends,” Balsara said. “The only catch is the insured has to pass away.”
Clients might also consider having their corporation establish and fund an individual pension plan, which allows the client to defer compensation while contributions grow tax-free.
“We still firmly believe that you want to have a mix of insurance-based strategies, pension plan-based strategies and traditional investments” for diversification purposes in a corporation, Bakish said.
However, the CGIR increase “almost pushes [clients] more toward” insurance and pension-based strategies.
Surplus-stripping strategies, which seek to convert dividends to capital gains to take advantage of the lower tax rate, have become less attractive, thanks to the CGIR hike and other policy changes.
“By raising the CGIR, we’re not on the exact same footing [in terms of tax rates for dividends and capital gains], but we’re much closer,” Spinner said. “The goalposts have narrowed.”
Why corporations still work for deferring tax
Incorporation will continue making sense after June 25 for business owners and professionals if they generate more income in their business than they need to fund their personal expenses, said Alexandra Spinner, tax partner with Crowe Soberman LLP in Toronto.
A Canadian-controlled private corporation in Ontario, for example, is taxed at the small business rate of 12.2% on the first $500,000 of active business income (ABI). Above that threshold, ABI is taxed at the general corporate rate: 26.5%.
In contrast, a sole proprietor is taxed at their personal marginal tax rate, which in Ontario tops out at 53.53% on income above $246,752.
When income is eventually withdrawn from the corporation as dividends, it will be taxed at the personal level. However, the significant difference in tax rates allows corporate owners to defer tax and direct more after-tax income toward investments. It’s “a huge head start — it’s like [having] a super RRSP,” Spinner said.
An owner could draw business income from their corporation to invest personally and take advantage of the 50% CGIR for gains less than $250,000, “but you may have to pay personal tax and give up deferral,” she said. “You can’t have your cake and eat it too [under the proposed change].”