Will they or won’t they?
That’s a question being asked these days by some nervous investors, worried that a government that has already targeted higher-income Canadians with new tax measures may also — perhaps as soon as the upcoming budget — choose to increase the capital gains inclusion rate.
Capital gains taxes, of course, are only a concern if you hold appreciated investments in non-registered accounts. All gains on securities held inside of registered accounts, such as RRSPs, RRIFs, RESPs, or TFSAs are either tax-deferred or tax-free. For non-registered assets, however, under the current rule, if you dispose of property (other than your principal residence) for a profit, only 50 per cent of the capital gain is included in taxable income. This results in an effective tax rate on capital gains equal to 50 per cent of your marginal tax rate on ordinary income. Depending on your province of residence, for high-income earners, the marginal tax rate on capital gains in 2017 can be as high as 27 per cent.
Although there was nothing in the Liberal Party’s 2015 pre-election platform to suggest an increase to capital gains tax, nor has the government floated the idea publicly, such a measure shouldn’t be ruled out, especially in light of other recent tax changes aimed specifically at higher-income Canadians.
These include asking “the wealthiest one percent of Canadians to give a little more” via the introduction of the 33 per cent high-income tax bracket for individuals earning more than $202,800 that helped pay for the middle-income tax cut.
Another change is the taxation of switching among classes of mutual fund corporations, which, prior to 2017, allowed investors to rebalance their portfolios within a mutual fund corporation on a tax-deferred basis. A change was also made to the taxation of linked notes, which are debt obligations issued by financial institutions that provide a rate of return that is “linked” to the performance of one or more assets or indices over the term of the note. Starting in 2017, a gain realized on the sale of a linked note will be treated as interest income.
For a government that has focused on tax measures targeting higher-income Canadians, a hike in the inclusion rate would be consistent with that approach
While some readers may fear that even writing about the possibility of the government increasing the inclusion rate might be putting ideas in the heads of the wrong people, Ottawa is well aware of the ability to tinker with the inclusion rate, as they’ve done so in the past.
Some readers may recall that prior to Jan. 1, 1972, Canada didn’t tax capital gains at all. Then came the Carter Commission Report, which recommended full taxation of capital gains. But the law, as originally introduced, only taxed 50 per cent of capital gains.
Subsequent governments increased the inclusion rate to 66.67 per cent in 1988, then increased it again to 75 per cent in 1990. A decade later, it was dropped back down again 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.
For a government that has focused on tax measures targeting higher-income Canadians, a hike in the inclusion rate would be consistent with that approach since the vast majority of capital gains are earned by the highest income-earners. Take the 2014 tax year, for example, in which 26.1 million personal tax returns were filed. Of those, less than 10 per cent reported having any taxable capital gains at all. When we dig deeper into who realized the $25 billion in aggregate taxable capital gains that year, we find that almost three-quarters (74 per cent) of those gains were earned by those reporting income of more than $100,000 that year, or the top 8 per cent of tax filers. Perhaps more revealing is that just over half of the total dollar reported taxable gains earned in 2014 were realized by those making over $250,000 annually, less than the top one per cent of income earners.
So, if you fear an increase in the capital gains inclusion rate, what do you do?
The answer depends on whether any such change would be retroactive or prospective. While it’s theoretically possible (and legal) for such a change to be retroactive (for example, to January 1, 2017), it’s unlikely the government would do so as it would be seen as profoundly unfair to retroactively increase the tax rate on dispositions as individuals would have taken into consideration the tax rate existing at the time they decided to sell the asset. Indeed, in the past, when the inclusion rates were changed, they were effective immediately on the announcement dates.
Assuming, then, that any increase won’t be retroactive, should you take steps to proactively realize any unrealized gains now, before any such increase takes effect?
The short answer is no. If it didn’t make sense to sell an asset prior to a tax rate increase, the fear of such an increase shouldn’t change your investment decision. That being said, investors need to always be mindful of the “capital gains lock-in effect,” which is the tax disincentive to sell an asset that has appreciated significantly in value, even if it may make sense to do so from an investment perspective, especially if an alternate asset’s future prospects look better than the current holding. An increase in the inclusion rate could cause some investors to be even more likely to avoid rebalancing their portfolio for fear of a hefty tax bill, thereby increasing the lock-in effect.
Bottom line? As the saying goes, “don’t let the tax tail wag the investment dog.”