Impact of Higher Capital Gains Inclusion Rate on Financial & Estate Planning

One change proposed in the April 16, 2024 Federal Budget is raising the inclusion rate on capital gains from 50% to 66.7%. For individual taxpayers, the initial $250,000 of capital gains remains taxed at the 50% inclusion rate. However, for corporations and trusts, the increased inclusion rate applies to all capital gains. These adjustments are slated to come into effect starting June 25, 2024.

What does this mean for individual taxpayers?

Income taxes on realized capital gains are increasing. For example, in B.C. with a top marginal income tax rate of 53.5%, taxes paid on capital gains under $250,000 are taxed at 26.75%. Now, for gains over $250,000 the tax rate increases to 35.85%. For most taxpayers, many of whom would not realize over $250,000 of capital gains in a taxation year, this change will not have any impact. However, for those who do realize such a gain the additional tax could be significant.

Consider someone who has just sold recreational property. If the amount of gain on that Whistler ski cabin, for example, was $500,000, the tax payable on the transaction will increase from $133,750 to $156,500. If that same property had been held in the family for generations the increase in taxes, with the new inclusion rate, could be substantial.

The same will be true for BC residents who own rental properties or investment portfolios that they wish to sell and generate profit. For each $100,000 of capital gain over the $250,000 limit they will pay an additional $9,100 in income tax.

The biggest potential impact of the increased inclusion rate on capital gains will be in estate planning. When a taxpayer in Canada dies, he or she is deemed to have disposed of all their capital property at fair market value. For estates with a large amount of non-registered investments, rental, and recreational property as well as other appreciable capital property, the inclusion rate of 66.7% will increase the final tax bill considerably.

What does this mean for owners of private corporations?

For private corporations (and trusts) there is no reduced inclusion rate for the first $250,000 of gain. Every dollar of realized capital gain is taxed based on an inclusion rate of 66.7%. Using the ski cabin in the first example, if that property had been held in a corporation, upon its sale, the full $500,000 would attract tax based on 66.7% inclusion, increasing the total tax payable to $179,150.

Many successful professionals earn their income in a private corporation retaining surplus income not required for immediate expenses to accumulate corporately for future use. The proposed tax increases on both corporate investment realization and shareholder access to proceeds have been substantial.

There is a vehicle for Canadian-Controlled Private Corporations (CCPCs) known as the Capital Dividend Account. This notional account allows a tax-free flow of the non-taxable portion of capital gains to the shareholder. The amount of tax-free capital dividends has now been reduced because of the increased inclusion rate. For instance, if a corporation realizes a $500,000 capital gain (using the example of a B.C. company with a 50.7% investment tax rate), the corporation’s tax liability would be $169,084, compared to the previous $126,750 with a 50% inclusion rate. Prior to June 25, 2024, the tax-free capital dividend flowing to the shareholder would be $250,000, decreasing to $166,500 thereafter. Consequently, more tax paid within the corporation translates to fewer tax-free proceeds for the shareholder.

For corporations, capital gains will increase their Adjusted Aggregate Investment Income (AAII) more quickly due to the higher inclusion rate. This will have the effect of accelerating the erosion of the Small Business Deduction (low rate of tax on the first $500,000 of active business income) which is reduced by $5 for every $1 of AAII.

Planning Opportunities and Strategies

What are some planning tips and strategies that can be used to mitigate the effect of these new provisions?

  • If you are holding investments with more than $250,000 in deferred capital gains, consider declaring them prior to June 25, 2024. This will require careful consideration as it will require tax to be paid sooner than originally expected. It may also have some Alternative Minimum Tax implications so take this strategy under advisement;

  • Consider a further diversification of your investments to limit capital gain exposure. Cash value life insurance, in particular Participating Whole Life, has been growing in popularity for several years, primarily due to its stable growth and tax-exempt status. This product could prove beneficial in a re-allocation of current investments;

  • Permanent life insurance products have long been used in providing necessary estate liquidity to pay taxes at death. With estates now having a possibility of higher taxes due to the higher inclusion rates, the amount of life insurance held for this purpose should be increased;

  • For owners of private corporations holding capital investments, consider allocating some of those investments to personal ownership to take advantage of the lower inclusion rate for up to $250,000;

  • Corporations should also consider diversifying and re-allocating corporate surplus to a tax-exempt life insurance policy owned by the corporation. This will shelter those investments from high passive corporate investment income tax as well as help protect the Small Business Income Tax rate on the first $500,000 of active business income;

  • You may also want to reassess corporately owned life insurance to help provide for the estate liquidity needs of the business owner, since the death benefit of the policy in excess of its ACB can be paid to the surviving shareholder or family tax free from the Capital Dividend Account.

As in previous budgets, there is currently no draft legislation enacting the provisions of the April 16th budget. Once enacted, however, the terms of the budget impacting the inclusion rate of capital gains will be effective June 25, 2024. It would be prudent to discuss your planning and develop strategies sooner rather than later.

Optimizing Wealth Through Asset Re-Allocation

If you are an active investor, your investment holdings probably include many different asset classes. For many investors, diversification is a very important part of the wealth accumulation process to help manage risk and reduce volatility. Your investment portfolio might include stocks, bonds, equity funds, real estate and commodities. All these investment assets share a common characteristic – their yield is exposed to tax. From a taxation standpoint, investment assets fall into the following categories:

Tax-Adverse

The income from these investments are taxed at the top rates. They include bonds, certificates of deposits, savings accounts, rents etc. Depending on the province, these investments may be taxed at rates of approximately 50% or more. (For example, Alberta 48.0%, BC 53.5%, Manitoba 50.4%, Ontario 53.53%, Nova Scotia 54.0%).

Tax-Advantaged

These investments are taxed at rates lower than those that are tax-adverse. These investments include those that generate a capital gain (stocks, equity funds, investment real estate, etc.), or pay dividends. The effective tax rate on capital gains varies depending on province from approximately 24% to 27%. For non-eligible dividends, the range is between approximately 37% to 49%.

Tax-Deferred

Tax-deferred investments include those investments which are held in Registered Retirement Savings Plans or Registered Pension Plans (such as an Individual Pension Plan). One advantage of these investments is that the contribution is tax deductible in the year it was made. The disadvantage is that the income taken from these plans is tax-adverse as it is taxed as ordinary income and could attract top rates of income tax.

The growth in cash value life insurance policies such as Participating Whole Life and Universal Life is also tax-deferred in that until the funds are withdrawn in excess of their adjusted cost base while the insured is still alive, there is no reportable taxable income.

Tax-Free

Very few investments are tax-free in Canada. Those that are tax-free include the gain in value of your principal residence, Tax-free Savings Accounts (TFSA’s) and the death benefit of a life insurance policy (including all growth in the cash value account).

While Canada is not the highest taxed country in the world (that distinction belongs to Belgium) it is certainly not the lowest. (According to the Organization for Economic Co-operation and Development, Canada sits as the 23rd highest taxed country in the world). It is also true that in addition to the taxes Canadians pay while they are living, the final insult comes at death.

Generally speaking, you have three beneficiaries when you die. You have your family, your favourite charities, and the Canada Revenue Agency. They all take a slice of your estate pie. Most people would rather leave more to their family and charities than pay the CRA more than they need to.

As our estates grow, they include funds that we intend to leave to our children and possibly to charity. They also include funds we are likely never going to spend while we are alive.

The secret to optimizing the value of your wealth for the benefit of your estate is to reallocate those assets that you are never going to spend during your lifetime from investments that are tax-exposed to those that are tax-free.

One of the best ways to do this is through life insurance. As mentioned earlier, assets which are tax-free include the death benefit of a life insurance policy. Systematically transferring funds from the tax-exposed investments to, for example, a Participating Whole Life Policy, not only eliminates the reportable tax on the funds transferred, it greatly increases the overall size of the estate to be left tax-free to your beneficiaries – your family and your charities.

Case Study

Let’s consider Ron and Sharon, aged 58 and 56 respectively. They have been told that they have a liquidity need of approximately $1,000,000 which would become payable at the second death. They are also unhappy about the taxes they are paying annually on their investments. They elect to reallocate some of their assets to a Participating Whole Life policy for $1,000,000 last-to-die policy with premiums of $35,000 per year for 20 years.

Over this period, they will transfer a total of approximately $700,000 of investments exposed to income tax to a tax-free environment. If we assume that their life expectancy is 34 years, the Whole Life policy will have grown to a death benefit of approximately $2,630,000*. This represents a pre-tax equivalent yield over this period of approximately 11%. Not only is there more than enough to pay the tax bill but there are funds left over for the family and any charitable donation they wish the estate to make.

In addition, with the transfer from a taxable to tax-free investment, income taxes that would have been paid during their lifetime has also been reduced. Along the way, the Participating Whole Life policy has a growing cash value account which could be borrowed against should the need arise. At the 20th year for example, the cash value of the policy (at current dividend scale), would be approximately $1,071,000.

This case illustrates only one example of how it is possible to optimize the value of an estate through asset re-allocation. By using funds you are never going to spend during your lifetime, you can create a much larger legacy to benefit others while reducing the total cost of your tax bill.

If you would like to investigate this concept to determine the value it can provide you and your family, please be sure to contact me. As always, please feel free to share this information with anyone you think would find it of interest.

* Values shown are using Manulife’s Par 100 Participating Whole Life policy assuming the current dividend scale with premiums paid for 20 years.