Capital gains tax changes and tax planning primer

The federal budget announced on April 17, 2024 makes some major changes that break tax integration for Canadian Controlled Private Corporation (CCPC) owners unfavorably. The effective tax rate will rise by 33.3%. A huge jump. This will also impact individuals realizing capital gains over $250,000 in a year.Fortunately, it will take effect June 25, 2024. So, there is going to be an opportunity to do some tax planning. This post will describe what the proposed change means and some basics that will factor into more advanced tax planning discussions that will follow. I will start super-basic and build.There are ways to deal with this change. How will depend on factors that we’ll unpack over a series of posts, and it could be a nothing-burger for many. Especially with some smart planning. My PWL Capital friends and I are also building some tools to help tax plan. I want to lay down a basic knowledge foundation today.Read: Loonie Doctor: How to stay tax efficient when donating to charityUnrealized vs. realized capital gainsA capital gain is the increase in value of an investment between the time you buy it and when you sell it. Before you sell it, those are unrealized gains and selling means realizing them. Tax is only due when the gain is realized. Taxing the gain prior to that would mean taxing the gain when you don’t have access to the money. That could force sales to pay taxes and create chaos. It is also hard to really know the value of something before it is sold.The realized gain is the difference between the value when sold and the adjusted cost base (ACB). Adjusted cost base is what you paid minus expenses. For example, subtracting transaction costs to buy the holding. For example, if I buy a stock for $100 today plus a $7 brokerage fee, the ACB is $107. Let’s say I sell it 20 years from now for $200. That would be a realized capital gain of $93. The tax would not be on that $93 profit until 20 years from now when it is sold.Capital gains inclusion rateOnly part of a realized capital gain is subject to tax. That is called the included gain or taxable gain. The excluded gain is tax-free. Why would a capital gain only be partially taxed? Because some of that increase in value is just due to inflation and does not represent an increase in buying power.Take the example of our $93 capital gain 20 years from now. Today, $93 would buy enough food to feed a family for a few days, or a teenager for one day. Twenty years from now, $93 may just buy me a coffee. Inflation ate my buying power. So, taxing that $93 fully would be an “inflation tax” rather than taxing a real increase in wealth.The other reason that capital gains are taxed at a lower rate is to encourage people and companies to risk capital to grow and innovate. That is part of how to grow a country’s economy and productivity beyond just population growth.The inclusion rate is the proportion of a capital gain that is taxed. Most recently it has been 50%, but it is now moving to 66.67% for corporations and large individual gains. So, two-thirds of the gain taxed instead of half. A 33% tax jump. How much of a tax break is required to encourage investment and account for inflation is debatable. So, it often varies based on government priorities and their balance sheet.Capital lossesIf you lose money on an investment, the capital loss can be used to offset capital gains. Either retroactively up to three years or carried forward as far as you want into the future. This is also an incentive to risk capital to build the economy. The government shares in your gains, but also your losses. Kind of like an investing partner. Thankfully, a silent one given their mixed “investment” and management track records.Only the included part of a capital loss is used to offset gains. So, half a loss when the inclusion rate is 50% and 66.67% of the loss at the new rate. During the transition, one report suggests previous losses at 50% inclusion will be allowed at 66.67% against new gains. I haven’t seen that in the government documents yet and listening to politicians talk about the budget is fingers on a chalkboard to me. There are just comments that more details are coming.Corporate capital gains taxationHow much tax you pay on capital gains from an investment in a corporation flowed through to personal after-tax money that you can spend involves several steps. There is tax in the corporation on the capital gain and personal tax on the dividends paid out.The included gain is taxed like passive investment income. That means roughly 50% tax upfront, applied to either half the gain now or two-thirds of the gain after June 25, 2024. So, about 25% before and 33% after. Part of that tax is refundable as nRDTOH when the corporation pays out non-eligible dividends to a shareholder. The shareholder pays tax on that non-eligible dividend at the marginal tax rate for their tax bracket.The excluded part of the capital gain is credited to the capital dividend account (CDA). That would be half currently, or one-third after June. A positive CDA balance can be used to pay out a tax-free capital dividend. That requires a special election to be filed that your accountant will usually charge a fee for doing.The process is outlined below (before the change) using a $100K realized capital gain. The inclusion rate change will shunt 33% more money to the left “taxed side” that is subject to corporate and personal tax.Tax integration compared to personal capital cainsThat flowchart was at the top Ontario tax bracket. The tax integration will vary slightly by province, but is similar and generally does not favor corporations already. The actual net tax rate will depend on your personal tax bracket. However, the relative efficiency of personal vs corporate capital gains was similar. Below is a high-level summary of the total tax integration before and after the change compared to personally.Prior to the change, corporations paid slightly more tax than an individual would. About 2% more in the chart below. After June 25, a corporation would pay about 12% more tax than an individual earning a capital gain directly. A massive punitive break in tax integration. If the individual is realizing a gain over $250,000, the portion above that is taxed more heavily. However, that is still about 3% less than a corporation flowing that capital gain through.The above table uses the top Ontario marginal rates. I have also built an online table that shows tax integration and tax deferral. Adjustable by province and showing all tax brackets. It also shows tax rates and integration for other forms of income. The dynamic tax table is housed here.Tax deferralThe tax rate on capital gains is only part of the story. Because tax is not due on a capital gain until it is realized, there is tax deferral. Avoiding tax now, but paying it later instead. A corporation adds an extra layer of tax deferral. That is the major benefit of a corporation. There is a low corporate tax rate on income now and the rest is paid later personally when a dividend is paid out.Tax deferral is generally good, but not alwaysI will give a simplified example to illustrate the point. The classic example is using an RRSP vs a TFSA. Both have tax-sheltered growth making them comparable. The biggest difference is that an RRSP means no income tax now and full income tax later. That is 100% tax deferral. In contrast, a TFSA is contributed to with after-tax money. So, full income tax now – but it comes out tax-free later. The mirror image.Let’s say that you have invest $1,000 of income to invest. You are in a 53.5% tax bracket. So, your RRSP contribution gets a 53.5% tax refund. The full $1,000 is invested. For the TFSA, you pay $535 tax and invest the remaining $465.Your RRSP grows way bigger due to the higher amount of initial invested capital. Like, double the amount.Eventually, you take the money out of the RRSP at the same tax rate as you contributed from.How much after-tax money do you have with each account? The same amount. Tax deferral now to the same rate in the future is not a tax savings.The hoped-for situation with tax deferral is deferral from a high tax rate now to a lower tax rate in the future. In that case, tax deferral is also tax savings. Leaving your more after-tax money to spend. This would be common for a high-income earner when they defer taxes during their big income and consumption years to a lower rate in retirement. Unfortunately, the opposite could happen. If you are in a very low tax-bracket now, and even if you expect that in the future relying on income-tested benefits, the tax deferral from an RRSP could cut the wrong way compared to a TFSA.Tax referral and capital gainsTax deferral from a low current to higher future tax rate makes tax deferral worse. The knee-jerk response to that with a known tax-hike on capital gains coming in a few months is to take the tax hit now at a lower rate rather than defer to a higher future tax rate. That is what the RRSP vs TFSA scenario would suggest. However, there is an important difference with capital gains.RRSP deferral vs. capital gains in a taxable accountInside the RRSP, the tax liability is building at the same rate proportional to the portfolio growth. So, when it is paid on exit, it takes its share of the profit. All capital gains within an RRSP are taxed as full income. However, in a tax-exposed account, like a non-registered personal or corporate account, capital gains are only taxed partially when realized. Not fully as income. So, as the portfolio and tax liability grow over time, the tax liability grows more slowly than it would for regular income.That difference becomes really powerful when you see the growth compound over time. Taking a tax-hit now at a slightly lower rate could be over-powered by the compound growth of the portfolio faster than the embedded tax liability growth over a long enough time frame. This is really hard for humans to wrap their head around. That applies to Excel-Human Cyborgs like me too. So, I made an excel model to show it. I will unpack it further in a future post and publish it when I clean up the messy coding.Lower tax-hit now vs. more compounding capital gainsTo give you a teaser and hopefully stop you from doing something impulsive, I will show a quick example. Below is a chart from someone realizing a $1MM dollar capital gain in the personal Ontario tax bracket. Three-quarters of that gain would be subjected to the higher inclusion rate after June 25, 2024. Nasty future tax bump. Taking the gain early ends the current tax-deferral journey at a lower tax rate. It then resets the ACB to zero to start building the tax liability at the higher tax-rate from scratch. Seems good. In fact, if you compare selling before June 25, 2024 to later this year—it is. About $50,000 more after-tax money tax by selling before the deadline.If your eyes didn’t just glaze over, you’ll notice that it isn’t the end of the story. After nine years, you would have come out ahead (including taxes) by not selling before June 25. The compounding of not realizing the gain, leaving it invested to grow capital and spit out income proportional to that eventually makes up for that tax savings.Time-frame, income mix, and growth rates matterFor this example, I used a simple 3%/yield divided evenly between eligible dividends, foreign dividends, and interest/rental income. Plus a 4%/year capital growth rate.The chart below shows liquidation of the portfolio at the higher capital gain rate for each data point. So, the end of the tax-deferral journey compared each year. As you can see, in this simple model, after about 9 years, having not realized the gain at the lower current rate gets overtaken by deferring.Don’t do anything rash if your planned timeframe is off in the distant future. Consult with your tax professional. Look at your current circumstances and long-term plan. I made this capital gains tax strategy calculator to help the discussion. It is for personal gains. The corporate one is in the works.Other factors for personal taxationThere are a few other factors to consider as well. The simulator accounts for these and I will illustrate in a separate post. However, they add to the case that your decision should be case-specific.If you are in a low current tax-bracket. Realizing a large capital gain now will bump up your current tax rate way more. Even moreso than that if you have kids in the mix and qualify for the Canada Child Benefit. Clawback of that income-tested benefit is effectively a further tax bump.The other issue is whether you will liquidate your capital gain all at once or not. If it is all in real estate. Then, it would be in large chunks with high transaction costs. If there are liquid fractional investments, like stocks, bonds, ETFs, or mutual funds. Then, you would likely slowly little those gains down in retirement. Probably below the current higher rate that kicks in at $250K. Of course, tax rates could rise dramatically in the future, but that is unpredictable about how or when.Corporate tax deferral and capital gainsTo add another layer, the question of a tax bump vs tax deferral gets more complicated when you are using a corporation. There is tax deferral from unrealized capital gains. Corporate active income has tax-deferral to allow more capital to invest. Realizing capital gains on purpose, a capital gains harvest, can even improve the corporate tax deferral if you would otherwise have to pay out taxable salary or dividends to fund your personal spending.Other factors enter into the equation. Particularly, how you pay yourself effects corporate tax deferral and efficiency profoundly. As does usage of other accounts strategically – like an RRSP or IPP, TFSA, and sometimes even a personal account. That will take another post to unpack some more. And another simulator. Fortunately, I have one and built future capital gains rate changes into it. This tax change was a bit wonky because it broke tax integration and has tiers personally. However, I am working on it. My friends are too. We’ve been building similar tools and comparing notes. Here’s a twitter post from Mark McGrath.What to Do? Pay attention. PlanI don’t know what the best strategy will be. As mentioned, it will be situation-specific for a personal taxable portfolio. Like a personal account, it will almost certainly be situation-specific and depend on multiple factors for a corporation. Time frame, compensation strategy, and other tax planning wrinkles will factor into the answer.My point is—don’t do anything rash. Like a human. Process this. Let your tax planners process it. The clock is ticking, but we have some time. I need to get plugged back into my Excel Docking Station, but I will share more as I work through it and share tools to help your discussions and planning. Check back in.The Loonie Doctor is a Canadian physician. The content in this article is for general illustrative and entertainment purposes only. See the original article here.

Capital gains tax changes and tax planning primer

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