How to plan for a potential hike in the capital gains inclusion rate
With the federal budget now set for March 22, 2017, investors with significant accrued capital gains in their securities portfolios are wondering whether a hike to the capital gains inclusion rate could be in the cards on budget day and, if so, is there anything they can do it about now.
Of course, investors need only be concerned with capital gains taxes if they hold appreciated investments in non-registered accounts. Under the current tax rules, if you dispose of capital property (other than your principal residence) for a profit, only 50 per cent of the capital gain is included in taxable income. Historically, the inclusion rate has been increased to 66.67 per cent in 1988, then increased again to 75 per cent in 1990, before being dropped back down a decade later to 66.67 per cent on Feb. 28, 2000 and then further reduced on Oct.18, 2000 to 50 per cent, where it has remained until today. But rumours have been circulating for weeks in the investment community that the inclusion rate may go back up on budget day.
Don’t let the tax tail wag the investment dog
A report authored last month by economist and lawyer Peter Spiro of the Mowat Centre, an independent public policy think-tank located at the School of Public Policy & Governance at the University of Toronto, sheds some light on the history of the reduced inclusion rate, among other tax preferences for investment income, asking whether these tax breaks can be justified on the grounds that they improve economic performance.
Spiro refers to oft-cited arguments justifying a reduced tax rate for capital gains on the basis that it encourages entrepreneurial risk-taking and compensates for “illusory” capital gains that are due to inflation. He contends that the reduced inclusion rate “does not target either of these well. The aim of avoiding tax on inflationary gains would be better achieved by explicitly exempting the portion of a capital gain that is due to general inflation. To the extent that it does encourage risk taking, it is questionably targeted. It provides just as much of a tax break to Canadians who speculate on foreign stock markets as to those who create new businesses in Canada.”
If you’re among those investors who fear that the government may, indeed, increase the inclusion rate, what can you do about it now? The easy thing to do is simply sell your appreciated assets and lock-in your capital gains tax bill at the current 50 per cent inclusion rate. But the problem with that is that if it didn’t make sense to sell an asset prior to a potential tax-rate increase, the fear of such an increase shouldn’t change your investment decision. As we often say, “don’t let the tax tail wag the investment dog.”
But there may be ways to have your cake and eat it too, albeit with some additional tax planning complexity and compliance costs. This week, in a note to clients, law firm McCarthy Tétrault LLP explained that it may be possible, depending on your circumstances, to crystallize any latent capital gains on your assets in order to benefit from the current inclusion rate. In addition, it may be possible to implement a crystallization strategy without having to pay tax in respect of the resulting capital gains if an increase to the inclusion rate is not enacted. It warned that these crystallization reorganizations would have to be completed before March 22, 2017 to be effective and as a result, “The window of opportunity is therefore closing quickly.”
Nigel Johnston, a tax partner in McCarthy’s Toronto office, explains that the basic strategy for appreciated securities is to sell the securities before the budget date to a Canadian holding company (either new or existing) in exchange for shares with a fair market value (FMV) equal to the FMV of the securities being transferred. This is a taxable transaction and triggers the capital gain.
If the March 22nd budget increases the capital gains inclusion rate, you do nothing more and have crystallized the gain at the current, 50 per cent inclusion rate. The cost of the securities to the Canadian holdco will be the securities’ FMV.
If, on the other hand, the budget does nothing, you file a “section 85” rollover election and elect that the securities be sold for tax purposes at their adjusted cost base (“ACB” or tax cost) so that no gain is realized. The cost of the securities to the Canadian holdco will be the elected amount (i.e. your ACB).
But, warns Johnston, “Since the strategy (assuming the inclusion rate is increased) involves paying the tax today (albeit at the lower inclusion rate), it doesn’t make sense if you are not contemplating a sale of the securities in the near future.”
That’s because taxes will be paid earlier than they otherwise would be and thus the time value of money needs to be considered in determining whether this strategy makes sense. In addition, you will now own your investment portfolio through a corporation, which adds a layer of complexity that you may not want. Annual corporate tax returns will need to be filed for the corporation and, if you want to take investment income out of the holdco, the corporation will have to declare dividends, which involve director’s resolutions and filing of T5 information tax slips.
So, is it worth doing?
“There have been lots of these rumours in the past, and nothing has happened. But if you do nothing, you could wake up on March 23 wishing you had done something,” adds Johnston.