Federal Budget 2024 - Capital Gains Inclusion on Corporations & Trusts

The 2024 Federal Budget raised the capital gains inclusion rate on corporations & trusts

Every dollar taxed inside a corporation as of June 25th will be subject to the new 2/3 inclusion rate which is a BIG DEAL.

Historically what would happen is as follows:

With a 50% inclusion rate – on a capital gain half the dollars are not taxed and flow into what is called the Capital Dividend account and can pass out tax free to the shareholder.

The other half is taxed at the corporate passive tax rate (50.17% in Ontario). Part of that tax can be “refunded” back to the corporation upon payment of a taxable dividend to the shareholder.

Now however – with the 2/3 inclusion rate – on a 100 dollar capital gain only $33.33 passes out via the CDA (So less tax free money in the shareholder’s hands). The rest would get taxed at 50.17%.

This means that yes there is more refundable tax but the net result is less “after-tax” dollars in the shareholder’s hands.

Shoutout to Benjamin Felix who did the math on this and came to the realization that this brings the effective tax of a capital gain form inside your corporation (once you pay everything out to yourself personally to over 38%! Prior it was 28.97 so this policy change has effectively raised the tax rate of a capital gain in your corporation by almost 10%.

This impact has a lot of downstream considerations to consider.

The value of incorporation – especially as a professional corporation

One of the main reasons for professionals to incorporate (such as Doctors, Dentists, & midwives) is to be able to defer tax in their corporation, pay a lower rate, have more dollars to invest, and then eventually pay themselves later when their personal taxes may not be so high.

Tax integration is the idea that when you flow money out to yourself from the corporation – it’s roughly the same as if you had earned it personally. Now – with this new change to corporate taxes – it’s very punitive to hold money passively in the corporation. While there is still a deferral benefit – the higher taxes will require a lot more thought about whether it makes sense – especially if capital gains will be taxed more punitively in the corporation.

Active corporations are a little different – they are using their money to grow an active business and this won’t apply as much in that area.

Holding corporations for passive assets including real estate

Holding corporations exist to keep money within the corporate structure (and inside that tax deferred status). Historically that made the most sense until money was needed personally in which case securities (or properties) sold and cash distributed out of the company. Knowing that these passive assets will have such a high tax rate going forward. There is a compelling argument for holding more assets outside the corporation in personal hands.

Real estate is doubly interesting here because one cannot sell “part” of a house. Therefore a large amount of gains will be subject to taxation at a higher rate in the future. This creates the next layer of challenges: Realize gains now or wait?

Trigger Capital Gains now?

With that increase on the horizon – it may make a lot of sense to sell off your portfolio in your corporation now, crystallize your capital gains at this lower 50% inclusion rate (and ALSO get a higher CDA since 50% flows into the CDA notional account).

The higher CDA plays a further downstream impact because you can pay those dollars out to yourself tax free. You then have those dollars personally which you can invest in your/your spouse’s name.

This is also beneficial because personally – the first $250K of capital gains per person is still subject to the 50% inclusion rate. It’s better to have those dollars in your hands personally to invest in this case.

On the surface it makes sense to sell everything right away. With that said however – that still means paying the tax now and then having less to invest going forward. With a long enough deferral horizon – deferred capital gains could still win out. More to come here.

The value of tax deferral accounts like RRSP/TFSA/RESP/FHSA/RDSP

Historically – people have been hesitant to fill up those shelters and preferred to leave more in their corporation to grow with flexibility (and avoid taxes on taking money out of the corporation). Now – with the taxation on capital gains becoming more punitive this makes the relative value of these registered accounts even bigger.

The RRSP/FHSA will potentially make a lot of sense almost from the beginning. With the others – there is usually a cross over period where with long enough tax deferred compounding (Because registered accounts allow for growth inside the account without taxation vs paying tax to remove money from the corporation) they will often overtake the corporation from a total wealth standpoint if deferred long enough. This increased tax on the capital gains in the corporation will make that timeline shorter where registered accounts make more sense vs corporations. Again more thoughts to come here.

Salary vs Dividends

Because of the value of the RRSP and now the after-tax return of investments in the corporation becoming less – this creates further support for the idea of paying one’s self Salary. Without getting into the details specifically it’s safe to say that if you liked CPP and RRSP room enough to pay yourself salary before…then you’ll like it even more now.

Passive income complications: RDTOH & AAII

Thanks Mark McGrath, CFP?, CIM?, CLU? for pointing these ones out to me. With the increase of what is “taxable” from the capital gain standpoint – this increases the amount of RDTOH that is generated. For many of these notional accounts – it is wise to clear them out as often as possible. A white paper by PWL details how important it is to clear out the notional accounts as they are essentially tax dollars sitting with the government being eroded by inflation. With increased RDTOH you now have more taxable dividends needed to clear the accounts out (and therefore more tax to pay overall).

Aggregate Adjusted Investment Income (AAII) refers to the passive income calculation that is done for the erosion of the small business ?deduction. Larger taxable portions of capital gains means quicker erosion of the small business deduction which then means higher taxes paid on the active income. Because more of the capital gain is being considered taxable income - this also now will create more AAII for the corporation...and thus make it easier to reduce the SBD limit.

In Kind Charitable Contributions just got a lot more attractive

In-Kind Charitable contributions were already beneficial. They allowed for a deduction to the corporation (in some cases against passive income). Additionally – instead of a 50% inclusion for the CDA, the government allowed a 100% amount added to the CDA.

Using the above example – that $100 capital gain – if the security was donated in-kind, yes the security and the $100 is gone. But the CDA amount grows by $100 and allows for a capital dividend to be paid out with other dollars. This resulted in cases where the “after-tax” impact of a large charitable contribution might have only been 50% of the after tax dollars in hand or even less.

Knowing that the future capital gains inclusion will be 2/3 going forward – this makes the relative benefit even stronger. More to come on this one.

Tax efficient investment strategies and thoughtful rebalancing just became more valuable.

Since the capital gain inclusion rate has gone up and starts from the first dollar of gains, every dollar of unnecessary realized capital gains in the portfolio will cost the corporate investor even more on an after tax basis.

Using Ben’s numbers from above – a portfolio that has 1% of realized capital gains every year just got 9.6 basis points less effective on an after tax basis.

2% of realized capital gains means 19.2 basis points of tax inefficiency.

If two portfolios are similar in asset class exposure & fees, but one has slightly higher turnover – that may be enough to swing the after-tax performance in favour of the other portfolio. Now more than ever – understanding the construction of your portfolio and how returns are generated will matter. (Especially since if you plan on donating your securities in kind as part of your corporate asset bleed down strategy you need as much deferred capital gains as you can get).

What about trusts?

Trusts will have a lot of the same issues on capital gains retained inside the trust. Therefore implications on sale of property and investments (ex. Investments held in trust for a minor that continue to grow over time) MUST be considered.

Additional implications for trusts are as follows:

-????????? Certain trusts are allowed to flow gains out of the trust and be taxed in the hands of the beneficiaries while retaining their investment characteristics. This means for Discretionary Family Trusts (Thanks Tim L. for the notes here) one could flow those gains out to the beneficiaries and they would then be taxed personally and subject to the capital gains inclusion rates personally.

-????????? This may also allow tax planning like multiplication of the LCGE to be preserved and additionally multiply the $250K initial inclusion rate across the beneficiaries

-????????? This does also impact planning around trusts. The 21 year rule is important to consider here as if anyone is coming up on? the 21 year rule with a forced disposition it may make sense to accelerate the disposition as well.

-????????? This also adds planning consideration around whether starting a trust before June 25th to take advantage of the original capital gains inclusion (ex. For an estate freeze) makes sense

More to come soon!

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