Tax Insights Published May 23, 2024 VOL. 01 NO. 01
By: Vishal Raithatha – CPA, CA, MMPA, B.A.Sc. Computer & Electrical Engineering
Planning under consideration
Effective June 25, 2024, capital gains tax rates are proposed to increase by about 8 – 10%, with the precise rate increase dependent on whether the capital gain is realized personally, corporately, or by a trust. It is critical to note that capital gains accrued but not realized prior to June 25, 2024, will not be “grandfathered”. I.e., when such gains are eventually triggered, they will be punitively taxed at the higher rates. It should also be noted that, to date, grandfathering rules have not been issued to deal with sales that are closed prior to June 25th where mortgages have been taken back so that the vendor is entitled to a reserve that defers a portion of the gain; if a portion of the gain is reported after June 24th, will the inclusion rate be one-half or two-thirds?
TZR TaxTM considers in this inaugural release of Tax Insights what action can be taken prior to June 25th to counter these legislative proposals by effectively “locking in” current lower capital gains tax rates on assets that may have appreciated such as real estate, marketable securities, and private company shares, without necessarily ridding oneself of them. It also considers other tax planning opportunities that a new capital gains tax regime may present.
Overview
It is worth noting at the outset that the strategy of triggering inherent capital gains prior to June 25th is often overblown.
Take the scenario where the intention is to sell an appreciated capital asset in the short-term. Unless it is a marketable security, it may not be prudent to rush a sale prior to June 25th as this may lower the price that can be commanded. However, it may be smarter to still opt to trigger the gain prior to June 25th, but without disposing of the asset (i.e., to “crystallize” the gain), and to pay the resulting tax at today’s lower rates. The cost base of the asset retained would be increased by the crystallized gain so that it is not taxed again on an eventual sale.
Crystallizing a gain on an asset that will be held long-term may not be prudent since the taxes prepaid could otherwise be invested and grown. Accordingly, the longer an asset is retained post-crystallization, the more the benefit of the lower tax rate would diminish and may ultimately cost the taxpayer.
That being said, there are many cases where triggering capital gains prior to June 25th will save significant dollars. Various strategies to accomplish this as well as other planning opportunities are discussed below.
Background
The government of Canada proposed in its 2024 Federal Budget release that the capital gains inclusion rate will, subject to certain exceptions, increase from one-half to two-thirds for sales that occur on or after June 25, 2024.
In Ontario, for an individual in the top marginal tax bracket, this would translate to an increased capital gains tax rate of 35.69% (up 8.92% from 26.77%) for capital gains in excess of an annual $250,000 limit (capital gains in a year up to the $250,000 annual limit will continue to be taxed at 26.77%). There is no indication if any type of trust (e.g., a “graduated rate estate”) will be entitled to the $250,000 exemption; therefore, Ontario resident trusts in the top tax bracket may be subject to a 35.69% tax rate (again, up 8.92% from 26.77%) on all capital gains. Finally, a corporation resident in Ontario would be subject to an increased capital gains tax rate of 33.44% (up 8.35% from 25.09%) at the corporate level; when the after-tax corporate proceeds are flowed out to an individual shareholder or trust in the top marginal tax bracket, the effective tax rate on the capital gain rises to 38.62% (up 9.65% from 28.97%).
General planning approach
This article discusses tax planning strategies with broad appeal.
Fundamental concepts that should be kept in mind when considering strategies to trigger a capital gain prior to June 25th are as follows and reiterated throughout the discussion:
- In cases where there is no desire to hold an appreciated capital asset beyond the short-term, a 3rd party sale should be considered prior to June 25th if commercially viable.
- If there is a desire to hold an appreciated capital asset after June 24th or if a 3rd party sale by then is not commercially viable, consideration should be given to employing crystallization methods that would trigger an “internal capital gain.” Triggering an internal capital gain would attract tax on the accrued gain at today’s lower rate without ridding the owner of the asset. The cost base of the asset would be increased by an amount equal to the gain triggered so that the gain is not taxed again on an eventual disposition to a 3rd party.
- The decision on whether to trigger an internal capital gain prior to June 25th will be heavily influenced by how far out a 3rd party disposition is expected, since triggering the gain now requires prepaying tax at current lower rates. Any benefit of the lower capital gains tax will diminish, and may eventually turn into a cost, the longer the asset is held because the taxes prepaid could otherwise have been invested.
- If there is uncertainty as to when an appreciated capital asset may be disposed of to a 3rd party, there are steps that can be taken prior to June 25th that would potentially enable the capital gain accrued prior to June 25th to be retroactively triggered effective pre-June 25th. It appears that such a strategy would enable access to today’s lower capital gains rates in hindsight if desired, subject to certain timing constraints based on the precise strategy employed. Retroactively triggering an internal capital gain would attract interest on taxes and late-filed election penalties.
- If a strategy to trigger an internal capital gain prior to June 25th as discussed above can be combined with “capital gains strip” planning, this may be the deciding factor in whether to trigger the internal capital gain.
Again, this article also considers tax planning opportunities other than the triggering of capital gains prior to June 25th.
Pre-June 25th planning strategies
Triggering real estate capital gains
Given recent real estate trends, it is common for capital real estate such as rental properties and family cottages to have significant inherent capital gains.
In cases where there is a desire to sell appreciated real estate in the short-term, despite the lower tax rate, it may not be sensible to endeavour to close the sale prior to June 25, 2024, if rushing it would decrease the price that can be commanded. As such, it may be beneficial to trigger an internal capital gain prior to June 25th; if this is done, caution must be exercised so as to not trigger Land Transfer Tax (“LTT”). All references to LTT below assume that the real estate in question is situated in Ontario and that any municipal LTT exemptions mirror the Ontario ones discussed.
Consider the two situations below.
#1 – Real estate held by an individual that will be sold in the short-term, where the individual’s aggregate capital gain in the year of sale (including the gain on the real estate) is expected to exceed the aforementioned $250,000 annual threshold.
An individual can trigger an internal capital gain by, for example, transferring their real estate to a wholly owned corporation. A capital gain can also be triggered by selling or gifting the real estate to a family member. If a gift is made to a spouse, in order to trigger the gain, an election would need to be filed to elect out of the automatic interspousal rollover provisions of subsection 73(1).
Subject to a narrow exception where an “active business” is run on the real estate by the individual owner or their family member (and not through a corporation of theirs), a transfer of real estate by an individual to a corporation will give rise to LTT, as would a transfer to an individual for consideration. However, a gift of real estate to an individual will not give rise to LTT provided that the gift recipient does not assume any portion of the transferor’s mortgage, if any, on the property.
If structured properly, an individual may transfer real estate to a partnership to trigger an internal gain without attracting LTT. That being said, if the transferee partnership is merely formed to facilitate the recognition of the internal capital gain, this may cast doubt as to whether the transferee partnership is in fact a partnership and therefore, doubt as to the validity of the internal gain triggered.
In summary, where an individual plans to sell real estate in the short-term, consideration should be given to either making the sale prior to June 25th or triggering an internal gain before then without attracting LTT. The following should be kept in mind with respect to avoiding LTT:
- Generally, the only way for an individual to trigger an internal gain on real estate while avoiding LTT is to gift the property to a family member if practical.
- If a gift to a family member is not practical, the individual can trigger the gain by transferring the real estate to a newly formed corporation, although this would generally attract LTT. If this method is employed, the individual should endeavour to sell the shares of the corporation (rather than have the corporation sell the real estate) in an eventual 3rd party sale at a higher price, given that the buyer would not be subject to LTT on a share purchase and would enjoy the cost base of the real estate to the corporation that will have been stepped up by virtue of the internal gain triggered.
- If circumstances permit, the use of a partnership can be considered to facilitate the creation of a capital gain without attracting LTT.
If there is uncertainty as to whether the real estate will be sold in the short-term, consideration can be given to gifting the property to a spouse. This is because the pre-June 25th gain will only be triggered if the abovementioned subsection 73(1) election is filed, which election can be filed in hindsight if desired up to ten years late pursuant to subsection 220(3.2) and regulation 600(b). This may be dangerous because the Minister may, but is not compelled to, accept the late election. If there is no spouse to employ this strategy, consideration can be given to utilizing a section 85 rollover election on a transfer of the real estate to a corporation which will allow the internal gain to be triggered in hindsight if desired for up to three years after the normal election filing deadline pursuant to subsection 85(7) (such a transfer to a corporation would generally attract LTT as discussed above).
#2 – Real estate held in a corporation that will be sold in the short-term
A corporation can trigger an internal capital gain by, for example, transferring its real estate to a wholly owned corporation (referred to below as the “recipient corporation).
Following the above example, if the recipient corporation holds the real estate for three years following the transfer, LTT will not be payable. If the recipient corporation sells the real estate in less than three years following the transfer, it will be liable for LTT.
If structured properly, a corporation may transfer real estate to a partnership to trigger an internal gain without attracting LTT. Again, if the transferee partnership is merely formed to facilitate the recognition of the internal capital gain, this may cast doubt as to whether the transferee partnership is in fact a partnership and, therefore, doubt as to the validity of the internal gain triggered
In summary, where a corporation plans to sell real estate in the short-term, consideration should be given to either making the sale prior to June 25th or triggering an internal gain before then without attracting LTT if possible. The following should be kept in mind with respect to avoiding LTT:
- Generally, the only way for a corporation to trigger an internal gain on real estate while deferring LTT is to transfer the real estate to an “affiliated corporation” for LTT purposes such as a wholly owned subsidiary.
- If this is done and the real estate is to be sold in less than three years from the transfer, one should endeavour to sell the shares of the affiliated corporation (rather than having the affiliated corporation sell the real estate). This would rid the seller of the affiliated corporation and cause the corporation to be liable for LTT, which would not be a disadvantage to the buyer who would be liable for LTT anyways on an asset purchase. In addition, the buyer would enjoy the cost base of the real estate to the affiliated corporation that will have been stepped up by virtue of the internal gain triggered.
- If the real estate is sold after three years, then the affiliated corporation would not be liable for the LTT if it sells the real estate.
- If circumstances permit, the use of a partnership can be considered to facilitate the creation of a capital gain without attracting LTT.
If there is uncertainty as to whether the real estate will be sold in the short-term, consideration can be given to utilizing a section 85 rollover election to transfer the real estate to an affiliated corporation for LTT purposes such as a wholly owned subsidiary. This would allow the internal gain to be triggered in hindsight if desired for up to three years after the normal election filing deadline pursuant to subsection 85(7) (such a transfer to a corporation would defer the LTT to the extent discussed above).
Triggering capital gains on marketable securities
In cases where there is no desire to hold appreciated marketable securities beyond the short-term, consideration should be given to selling them prior to June 25th.
Where there is a desire to hold appreciated marketable securities after June 24th, the methods of triggering an internal capital gain must be weighed against the professional fees required to do so. Rather than trigger an internal gain, subject to any transaction fees that may apply, a taxpayer may wish to simply sell an asset prior to June 25th and then immediately repurchase it at the higher cost.
As always, the decision on whether to employ one of the above strategies will be influenced by how far out a 3rd party disposition is expected since triggering a gain now will require prepaying tax at current lower rates, any benefit of which will diminish the longer the asset is held as the taxes prepaid could otherwise be invested.
Triggering capital gains on private company shares
Potential strategies with respect to appreciated private company shares should be assessed. This may be critical if there is an intent to sell the shares in the foreseeable future or if there are elderly shareholders. These two situations are discussed immediately below.
#1 – Business sales
If it is expected that the shares of a private corporation may be sold in the foreseeable future, it would be prudent to consider what steps can be taken now to lock in today’s current lower capital gains rates on any portion of the resulting capital gain that would not be sheltered by the “lifetime capital gains exemption” (“LCGE”). In this regard, it should be noted that the 2024 Federal Budget proposed a favorable measure that would increase the LCGE limit that an individual may claim from $1,016,834 in 2024 to $1,250,000 for sales that occur after June 24th.
The analysis that follows assumes that a 3rd party business sale prior to June 25th is not commercially viable and/or not desirable and that the capital gain that would result on an eventual sale cannot be fully sheltered by the shareholder(s) LCGE(s) and/or afforded current capital gains rates by virtue of the $250,000 annual individual exemption.
Given the commercial reality that most proposed business sales fall through, it appears that it may be advisable to ensure that any pre-June 25th steps do not automatically trigger an internal gain prior to June 25th.
Rather, similar to the discussion above pertaining to real estate planning strategies, consideration can be given to utilizing a section 85 rollover in any planning. For example, the shares of an operating company (“Opco”) or a portion thereof can be transferred to a newly formed corporation (“Newco”) prior to June 25th and the section 85 elected transfer price can be determined in hindsight, up to 3 years after the regular election filing deadline.
In the above example, if it appears that a share sale will not occur, the transfer price can be elected at the cost of the Opco shares so that an internal gain is not triggered. Conversely, if the sale of shares is guaranteed or if it appears that it will happen, the section 85 elected transfer price can be set at the fair market value (“FMV”) of the Opco shares at the time of the transfer, which would result in a capital gain pre-June 25th taxed at the lower capital gains rate. The cost base of the Opco shares to Newco would equal the FMV of the Opco shares at the time of transfer, so that when Newco in turn sells the Opco shares the gain that accrued pre-June 25th would not be taxed again.
There are more intricate sale strategies involving the deliberate triggering of section 84.1, safe income strips, maximizing the benefit of the LCGE, etc., or a combination thereof. Setting up the most efficient sale structure pre-June 25th without automatically triggering an internal capital gain is complex, so the professional fees to do so must carefully be weighed against the likelihood and timing of a future business sale.
Finally, given the abovementioned budgetary proposal with respect to the increasing LCGE post-June 24th, it may be prudent to stagger the gains (i.e., trigger internal gains on a portion of the shares pre-June 25th, but keep another tranche of shares so that the expected higher post-June 24th LCGE can be maximized).
#2 – Estate planning
The higher capital gains tax rates may apply to the deemed disposition of a capital asset on death. Consideration should be given to triggering inherent gains on, for example, private company shares during a shareholder’s lifetime rather than waiting until death, especially if the shareholder is elderly.
Similar to the above strategies, triggering a gain prior to June 25th would necessitate prepaying tax at today’s lower rates, any benefit of which will diminish the longer the asset is held and the taxes prepaid could otherwise be invested.
Capital gains strip planning
If triggering an internal capital gain on an appreciated asset prior to June 25th under one of the above strategies could be implemented in conjunction with a strategy to extract corporate surplus at cheaper capital gains rates (commonly referred to as a “capital gains strip”), this may be the deciding factor in whether to trigger the internal gain. The author briefly considers this below and also comments on the possibility of implementing a capital gains strip prior to June 25th in isolation. A full discussion of capital gains strip planning is beyond the scope of this article.
The Canada Revenue Agency (“CRA”) stated in its Technical Interpretation 2024-1016011E5 that the General Anti-Avoidance Rule (“GAAR”) will generally not apply to internal capital gains triggered prior to June 25th. However, they go on to say that the GAAR may apply where tax benefits in addition to avoiding the higher capitals tax rate are sought, such as the extraction of surplus at capital gains rates (i.e., a capital gains strip).
Accordingly, it appears that, where an internal capital gain is triggered by a corporation prior to June 25th, caution would have to be exercised if corporate surplus is to be extracted leveraging the favorable tax attributes created by the gain (i.e., the inclusions to the tax-free capital dividend account and refundable tax balance), prior to a 3rd party sale of the underlying asset giving rise to the capital gain.
Notwithstanding the above, given the proposed higher capital gains tax rate, strong consideration should be given to whether a capital gains strip can be achieved prior to June 25th (either in conjunction with triggering an internal capital gain or in isolation) without running afoul the GAAR as amended effective January 1, 2024. A discussion of this including types of transactions that may possess the necessary “economic substance” under the amended GAAR provisions are beyond the scope of this article.
The above analysis does not extend to situations where an individual sells an appreciated capital asset to their corporation to trigger an internal capital gain and extracts corporate surplus equal to the FMV of the capital asset. Accordingly, it would be prudent for an individual to consider selling long-term appreciated capital assets (e.g., subject to LTT considerations a rental property) to their existing corporations if there is, or will be in the foreseeable future, a desire to extract corporate surplus therefrom without liquidating the long-term asset transferred thereto.
Additional planning considerations
Post-June 24th corporate capital gains – income treatment over capital treatment?
Whether a gain realized by a corporation constitutes business income or a capital gain is not always black and white.
Under the current capital gains tax regime, it would be rare for a corporation to take a business income position where capital treatment could be supported since the tax deferral, if any, would be small given the current 25.09% corporate capital gains rate. The deferral, if any, would typically be outweighed by the significant additional cost of flowing out the funds to the end individual shareholders. I.e., the total tax on business income flowed out to an individual shareholder in the top marginal tax bracket would exceed 50%, whereas a pre-June 25th capital gain flowed out to such an individual would attract total tax of 28.97%.
If a reasonable position can be taken to support either treatment after the higher capital gains rates take effect, a corporation may consider the position of treating the gain as business income as this would provide a tax deferral. I.e., in Ontario, an income gain would attract corporate tax at a rate between 12.2% and 26.5% depending on the availability of the Federal and Ontario “small business deductions” (“SBDs”), whereas a post-June 24th capital gain would attract immediate corporate tax at a rate of 33.44%. Unfortunately, if income treatment is correct, the total cost when flowing out the after-tax corporate funds to an individual shareholder in the top marginal tax bracket would exceed 50%, whereas a post-June 24th capital gain flowed out to such an individual would attract total tax of 38.62%.
Investing in new capital assets
Unless additional measures are introduced to more or less preserve integration, it appears that the $250,000 annual limit available to individuals will make it more attractive to earn capital gains personally as opposed to corporately, provided that excess personal funds are available for investment. I.e., if personal funds are utilized to make an investment, it would not necessitate the extraction and taxation of corporate surplus to fund living expenses.
This is because, if an individual earns capital gains of $250,000 or less in a year, the maximum tax rate that would apply is 26.77%. A capital gain earned by a corporation would be taxed at 33.44% at the corporate level irrespective of the quantum of gains, with the total effective tax rate rising to a maximum of 38.62% when the after-tax corporate proceeds are flowed out to an individual.
In addition to the lower capital gains rate on the first $250,000 of annual gains, earning capital gains outside an associated corporate group may preserve the SBD or a portion thereof to the group, a discussion of which is beyond the scope of the article.
Lastly, consideration can be given to splitting capital gains income with family members, including minor family members, either directly or via a trust. Under this type of planning, the fact that there is no attribution of capital gains income from children (regardless of age) to parents may be leveraged.
Final remarks
As mentioned at the outset, in many instances, the strategy of triggering capitals gains prior to June 25th is overblown. E.g., if an internal capital gain is triggered on an asset that will be held long-term, although the tax would be at a lower rate, it must be paid now. Prepaying tax reduces the funds available for investment.
However, there are also situations in which employing the above planning strategies would save significant dollars.
No planning is complete without considering the potential impact of the GAAR. In fact, it is not possible to formulate a tax plan without the caveat that, although the plan may be technically perfect in that it does not violate any specific tax provision, the CRA may try to attack it on the basis that it violates the GAAR rules because it constitutes abusive tax avoidance.
Substantially amended GAAR rules took effect on January 1, 2024. The amended rules contain a new economic substance test. Also, the new rules specify that a transaction is considered to be an “avoidance transaction” potentially subject to the imposition of GAAR unless one if its main purposes is not to obtain a tax benefit.
Unfortunately, based on past history, we will have to wait considerable time before we see how the CRA, and ultimately the courts will interpret the amended GAAR in connection with specific tax plans. Therefore, in deciding whether a particular tax plan should be implemented, the judgment of the advisor who has suggested the plan must be relied upon.
Finally, there has been speculation that the proposed capital gains tax legislation, if passed, may be repealed in the near future, especially if a Conservative federal government is elected. Some taxpayers may wish to “gamble” by factoring this possibility into their planning process.
The above content is for informational purposes only and is general in nature. It is not intended to be advice. No person or entity should act upon the information above without receiving professional advice after all the facts and circumstances specific to their situation are thoroughly reviewed.