Advisors and clients disappointed by the absence from this year’s federal budget of a key Conservative election promise to establish a capital gains rollover for gains reinvested within six months should not give up hope.

Ottawa is still considering this measure, says Jamie Golombek, chairman of the Investment Funds Institute of Canada’s tax issues committee.

Meanwhile, Golombek and other tax experts point to two key changes in the budget that advisors can use to generate further planning business with clients: elimination of capital gains taxes on publicly donated securities, and changes to the tax treatment of dividends.

Tax experts didn’t really expect to see the capital gains rollover in the 2006 federal budget. It will cost Ottawa at least $425 million in lost revenue, and the rules required to make it happen would be complex.

However, in mid-May, Golombek and IFIC’s new president and CEO, Joanne De Laurentiis, met with Conservative MP Diane Ablonczy, parliamentary secretary to Finance Minister Jim Flaherty.

Among the issues discussed with Ablonczy was the capital gains rollover. “We were encouraged. She expressed interest in this issue, in particular,” Golombek says.

Many other tax experts have been advocating this change, including Jack Mintz, president and CEO of the Toronto-based C.D. Howe Institute.

Some critics of the rollover say that capital gains taxes have the effect of encouraging investors to hold on to assets instead of bailing out prematurely. They also prevent investors from “stripping” surplus income, in the form of capital gains, from companies, Mintz says.

But capital gains taxes also result in a “lock-in” effect, he says. They discourage investors from selling stocks with built-up capital gains unless they have capital losses to write off against them. “[Investors] don’t want to pay taxes,” he says.

Therefore, tax policy-makers have to “strike a balance,” Mintz says. He recommends a limited capital gains rollover. In an April 2006 paper that he co-wrote with Thomas Wilson for the C.D. Howe Institute entitled Removing the Shackles: Deferring capital gains taxes on asset rollovers, Mintz suggests the rollover take the form of a “capital gains deferral account.”

The CGDA could be used to monitor the accrual of capital gains and ensure that the proper amount of taxes are paid when a withdrawal is made.

Mintz also says the rollover should be available to individual taxpayers, not corporations, which already benefit from a variety of capital gains tax breaks.

Investors who make better investment choices should not be penalized, he says. Therefore, a limit should not be placed on the amount of capital gains that an individual can accrue. However, he says, a capital gains rollover should be designed to provide greater benefit to smaller investors. Therefore, he suggests a lifetime contribution limit to the CGDA of $150,000. This will also prevent too much erosion of federal revenue, he adds. Based on this limit, Mintz estimates a revenue drain of $425 million for federal and provincial governments.

Ottawa’s elimination of capital gains taxes on donations of publicly traded securities was widely welcomed by the country’s 82,000 registered charities, says Jo-Anne Ryan, vice president of philanthropic advisory services at TD Waterhouse Canada Inc. : “We’re very happy about it.” (The change took effect on May 2.)

TD Waterhouse economists estimate the value of securities held by Canadians is $1.3 trillion, she says, adding that approximately half that amount consists of unrealized capital gains. With this tax change, she estimates, securities donations will increase by 50%, amounting to an influx of an extra $100 million for charities.

The tax change will allow advisors to play a key role in opening a discussion about planned giving with clients, Golombek says.

And advisors to charities should make the donation process as easy as possible, Ryan says. Charities should open brokerage accounts with all the major firms to make donations quick and easy for donors: “[Donors] won’t want it to take three weeks, when the market could plummet and the value of their donated securities will drop.”

Another tax change, an increase in the federal dividend tax credit that applies to the treatment of “eligible dividends,” will open the door to conversations with clients who own and manage their own companies.

Income earned by corporations is subject to corporate taxes, and dividends distributed to individual shareholders are subject to personal income taxes. Ottawa and the provinces have a complex integration model, using a combination of federal and provincial dividend tax credits, that attempts to relieve the impact of double taxation.

@page_break@The intent is to integrate the level of taxation of income that has been subject to both corporate and personal taxes.

Under the current system, public companies are taxed at a higher rate (32%) than small Canadian-controlled private companies (20% on active business income), and the integration model works better for CCPCs. The budget provisions are increasing the federal tax credit and extending the integration model to public companies.

Due to gaps in the integration model, clients who pay themselves from their own companies’ revenue historically “bonus out” the surplus cash in their companies to themselves at the end of the year rather than pay themselves a dividend. Many tax experts predict this will change. Owner/managers are more likely to pay themselves a dividend.

However, Heather Evans, partner and tax lawyer with Deloitte & Touche LLP in Toronto, is cautious. The federal Finance Department still has to come out with the actual legislation. “The devil will be in the details, particularly when it comes to tracking ‘eligible dividends’ that may have been paid by the owner/manager’s operating company to his holding company.”

Further, say Evans and Golombek, the effectiveness of these measures will depend on whether the provinces follow Ottawa’s lead, and increase their dividend credits, too.

If they do, “integration” should be achieved by 2010, when the combined federal/provincial average corporate tax rate is expected to be 32%, Golombek says. IE