Budget 2024 Part 1: Capital Gains Inclusion Rate
What Changed?
Following the recent release of the 2024 Budget, numerous tax reforms and changes have been introduced, with some changes being more impactful than others. In this blog, we will be discussing arguably the most impactful tax change from the budget - the increase of the capital gains inclusion rate from 50% to 66.67% for any dispositions after June 24th of this year and for all gains in a tax year for future years.
This blog will break down some on the important points and help you understand what this could mean for you and your business. Let’s get started.
What does this mean for me?
If you have less than $250,000 of capital gains per year, then these changes won’t have a significant impact on you. Individual taxpayers, as well as Graduated Rate Estates (GREs) and Qualified Disability Trusts (QDTs), have access to a $250,000 annual exemption from this increased inclusion rate, and the old rate of 50% will still apply to any gains under this exemption threshold. For any capital gains in excess of the $250,000 exemption threshold, the new inclusion rate of 66.67% will apply. Corporations and other types of trusts, however, will have the new 66.67% inclusion rate on all capital gains; they are not entitled to the same annual exemption amount.
This applies to capital gains (including those allocated from a partnership or trust) after applying capital losses, lifetime capital gains exemption (LCGE), employee ownership trust tax exemption, and Canadian entrepreneurs' incentive rate reduction. Capital losses of previous years, where the 50% inclusion rate applied, that are carried forward against future capital gains will be adjusted at the new inclusion rate.
Gains Received by Individuals Through Trusts/Partnerships
Although a trust or partnership can earn capital gains throughout their fiscal year, these will not actually be allocated to their beneficiaries/partners until the end of the taxation year. Without any specific transitional relief, this would mean that a capital gain incurred by a partnership or trust between Jan 1, 2024 and June 24, 2024 would be technically subject to the increased inclusion rate of 66.67%. However, because this would obviously not represent fair tax treatment for capital gains earned through these entities, there is a transitional rule in place for 2024.
This rule states that all capital gains earned through trusts/partnerships with tax years that begin before June 25, 2024 and end after June 24, 2025 will be grossed up to their original amount, and be deemed to be recognized by partners/beneficiaries on the actual date the gain was recognized (and thus subject to either 50% or 66.67% inclusion rate, as appropriate).
Imagine that you have a trust with a December 31 year-end that owns an investment portfolio. There is a sale of investments during the year and the trust made $1,000 of capital gains in March 2024, when the 50% inclusion rate was still in effect. Without the transitional rule above, this gain would be allocated to a beneficiary on December 31, 2024, and therefore they would report $666.67 as taxable income on their tax return. However, with the transitional rule in place, the beneficiary would instead only report $500 as taxable income on their tax return, since the gain was realized when the 50% inclusion rate was in effect.
Capital Gains Reserve
When selling a property and receiving the sale proceeds over a number of years, taxpayers will often claim what is called a capital gains reserve. This effectively works to spread the capital gain out over the period that the proceeds are collected over. What actually happens is that a deductible amount (the reserve) is calculated each year according to a specific formula. This calculated amount is deducted from the amount of capital gains in the year. Then in the next year, the amount of the previous year’s reserve is brought into income as a capital gain, and the reserve calculation is done again with a new reserve amount deducted against the income.
For taxation years that include June 25, 2024, if there is a previous year’s reserve to be brought into income in that year, it will be subject to the 50% inclusion rate. If there is a reserve deducted against that amount, when that reserve comes into income in the following year, it will be at the 66.67% inclusion rate.
Net Capital Losses
Capital losses will be adjusted to match the inclusion rate of the period that the gains they are being applied against.
Imagine you have a capital loss of $1,000 from 2023 when the inclusion rate was 50%. This means that the loss could effectively reduce your taxable capital gains by $500. Let’s say in your taxation year ended December 31, 2024, you have capital gains of $1,000 that would be subject to the 66.67% inclusion rate ($666.67 of taxable income). Since the inclusion rate has increased to 66.67%, your capital loss of $1,000 would be used to offset $666.67 of taxable income. If you were instead to carry that loss back against capital gains earned in 2022, that same amount of loss would only be used to offset $500 of taxable income. This would mean that your $1,000 loss is now more impactful against future capital gains due to the higher inclusion rate.
Capital Dividend Account
The balance of the capital dividend account is increased by the non-taxable portion of capital gains. Before declaring the payout of this tax-free dividend, the balance of the capital dividend account needs to be calculated at the date of the proposed payout. According to the original proposals released by the Department of Finance, additions to the capital dividend account for 2024 tax year will be based on a blended rate instead of based on the inclusion rate on the date each gain was triggered. The blended rate is based on calculating the taxable capital gains in both periods using the appropriate inclusion rate, and then dividing that figure by the total gross capital gains for the year.
For example, if $5,000 gain realized at 50% inclusion and $1,000 gain realized at 66.67% inclusion, the addition to CDA for both would be at 47.22%
$5000 @ 50% inclusion = $2500 taxable portion
$1000 @ 66.66% inclusion = $666.67 taxable portion
Total capital gain = 5000+1000 = $6000
Total taxable portion = 2500+666.67 = $3166.67
Capital dividend account addition = 6000-3166.67 = $2833.33
Blended rate = 2833.33/6000 47.22%
Therefore, this blended rate will not be known until the end of the taxation year, and caution should be exercised before making 2024 capital dividend elections. However, recently Department of Finance released some additional proposals to address this lack of clarity in calculating the balance of the capital dividend account during the transition year. The above will still hold true for the year-end capital dividend account balance calculation, but during the year at any point in time, the gains and losses will be added or removed from the capital dividend account using the inclusion rate in effect when the gain/loss was realized. At year-end, the taxpayer will be deemed to have realized a capital gain or loss to bring their capital dividend account balance to actual according to the blended rate applied against all gains/losses during the year.
Conclusion
As you can tell from the summary above, the change to the capital gains inclusion rate raises a number of complex issues for taxpayers with frequent capital gains/losses. Now is an important time to have your capital gains and losses assessed to understand how the new inclusion rate will impact your overall tax situation. Adjustments to investment strategies and tax planning might be necessary to mitigate the impact of the higher inclusion rate.
The 2024 Budget changes mark a significant shift in the taxation of capital gains, emphasizing the need for proactive financial and tax planning. Stay informed about these changes and consult with tax professionals to navigate the new landscape effectively.
Stay tuned for further updates as we will continue to analyze and discuss other noteworthy changes introduced in the latest budget report. Understanding these modifications will be crucial for optimizing tax strategies and ensuring compliance with evolving tax regulations.