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What does the capital gains inclusion rate change mean for you?
28 Oct 202411 min read
The federal government has introduced more details on the proposed changes to the capital gains inclusion rate, which were first announced in the 2024 federal budget. If enacted, individuals, trusts, and corporations may have to include a greater portion of their capital gains in their taxable income. Specifically, for corporations and most trusts, 66.67% of capital gains realized on or after June 25, 2024 would generally need to be included in income for tax purposes (up from 50%). For individual taxpayers, the increased rate would only apply to the portion of capital gains that exceed $250,000. Capital gains under the $250,000 threshold realized by an individual either directly or indirectly through a trust or partnership will remain subject to the 50% inclusion rate each year. Graduated rate estates (GREs) and qualified disability trusts (QDTs) would also be eligible for the $250,000 threshold available to individuals. This would apply to capital gains taxed in the trust rather than allocated out to beneficiaries.
If enacted, the new rules will be effective June 25, 2024. The proposed increase to the capital gains inclusion rate has widespread impacts. Reach out to your tax advisor to assess how these proposals might affect you, your trust, or your corporation.
Legislative background
The federal government approved a Notice of Ways and Means Motion (NWMM) to introduce legislation for the capital gains inclusion rate change on June 11, 2024, and released additional technical amendments in August and September 2024. In October 2024, the federal government proposed to put the capital gains measures to a confidence vote. This means that there would need to be a majority vote for these changes to become law and the current government to continue in power. This puts into question if and/or when the proposals become law. We’ll update this article with any further developments.
Transitional rules
For tax years that include June 25, 2024 (i.e., the transition year), two different basic inclusion rates would apply. The inclusion rate that is generally applied to capital gains (or capital losses) throughout the year will be as follows:
For corporations and trusts (other than GREs and QDTs), this effectively provides a blended inclusion rate throughout the year but preserves the 50% inclusion rate in Period 1 and the 66.67% inclusion rate in Period 2. For individuals (including GREs and QDTs), a blended rate would also apply; these taxpayers are entitled to the 50% inclusion rate for all dispositions in Period 1 and are also entitled to the 50% inclusion rate for the first $250,000 of capital gains in Period 2.
Example 1: If a Canadian private corporation (Canco A) had a net capital gain of $400,000 in Period 1 and a net capital gain of $600,000 in Period 2, the capital gains inclusion rate for the year would be a blended rate of 60% (i.e., 50% on the $400,000 in Period 1 and 66.67% on the $600,000 in Period 2). Canco A’s taxable capital gain would be $600,000.
Example 2: If a Canadian individual (Individual A) had a net capital gain of $400,000 in Period 1 and a net capital gain of $600,000 in Period 2, the capital gains inclusion rate for the year would be a blended rate of 55.83% (i.e., 50% on the $400,000 in Period 1, 50% on the first $250,000 in Period 2, and 66.67% on the remaining $450,000 in Period 2). Individual A’s taxable capital gain would be $558,333.
In this scenario, whichever period has the higher absolute value will determine which inclusion rate to use. If Period 1 has the higher amount, the capital gains inclusion rate would be 50%. If Period 2 has the higher amount, it will be 66.67%. This transitional rule essentially ignores the different inclusion rates for Period 1 and Period 2.
Example 1: If a Canadian private corporation (Canco B) had a net capital gain of $400,000 in Period 1 and a net capital loss of $200,000 in Period 2, the capital gains inclusion rate would be 50%, since the capital gain in Period 1 is the higher absolute value. Canco B’s taxable capital gain would be $100,000. If Canco B had a net capital loss of $200,000 in Period 1 and a net capital gain of $400,000 in Period 2, the capital gains inclusion rate would be 66.67%, since the capital gain in Period 2 is the higher absolute value. Canco B’s taxable capital gain would be $133,333.
Example 2: If a Canadian individual (Individual B) had a net capital gain of $400,000 in Period 1 and a net capital loss of $200,000 in Period 2, the capital gains inclusion rate would be 50%, since the capital gain in Period 1 is the higher absolute value. Individual B’s taxable capital gain would be $100,000.
Net capital loss carry-back
If the capital gains inclusion rate for the year that the net capital loss is generated is different from the inclusion rate for the year that it’s applied, the amount of the net capital loss will be adjusted to reflect the inclusion rate for the year in which it’s applied. For example, if a taxpayer generates a net capital loss in 2025 (66.67% inclusion rate) and carries it back to reduce taxable capital gains in 2023 (50% inclusion rate), the net capital loss will be deducted in 2023 at the 50% inclusion rate.
Capital dividend account
The capital dividend account (CDA) keeps track of the non-taxed portion of capital gains realized by Canadian private corporations. When there is a balance in the account, a corporation can pay out an amount not exceeding the balance as a capital dividend. Canadian-resident shareholders can then receive this capital dividend tax free. Any amounts that were added to the CDA before these rules are enacted will not be altered by the proposed legislation (e.g., the 50% non-taxable portion of any net capital gains for a December 31, 2023 fiscal year would not be retroactively affected).
Transitional rule for CDAs
A transitional rule, proposed in the August technical amendments, applies the 50% capital gains inclusion rate for dispositions occurring before June 25, 2024, and 66.67% for dispositions occurring after June 24, 2024. This proposed transitional rule provides certainty on the amount and timing of CDA additions. Without this transitional rule, the inclusion rate applied to capital gains or losses for the CDA wouldn’t be known until the end of the fiscal year including June 24, 2024. Additional transitional rules for CDAs were introduced to provide for an adjustment at the end of the tax year so that the CDA additions would end up being subject to the blended effective capital gains inclusion rate, as if under the general transitional rules. This will allow taxpayers to pay out capital dividends from their CDA with certainty in the transitional year while also ensuring the CDA balance is neither overstated nor understated at the end of the year when considering the general inclusion rate for the transitional year.
Similar to net capital losses, the capital gains inclusion rate for amounts in the CDA will depend on when the capital gain is realized.
Capital gains reserve
When capital property is sold, a taxpayer may realize a capital gain. Where a taxpayer receives the proceeds from the sale over multiple years, they may be able to claim a reserve to include the capital gain in their income over a period of up to five years.
When a taxpayer claims a reserve to offset a capital gain, the reserve that is claimed must be included in their income for the subsequent year. When the taxpayer claims another reserve in that subsequent year, the difference between the old reserve and the new reserve will be the portion of the capital gain recognized in that subsequent year.
The portion of the capital gain that’s included in income each year will be subject to the inclusion rate that applies for that particular year (i.e., not the inclusion rate that existed in the year the sale occurred).
We believe this could present a problem for sales that occurred before the transition year, and then the taxpayer must determine how much of a reserve (if any) to claim in the transition year. As the prior year reserve is included in the current year’s income, it’s unclear whether the income inclusion occurs before or after the change in the inclusion rate.
The draft legislation proposes that, in a tax year that includes June 25, 2024, the prior year reserve is deemed to be included in income on the first day of that tax year (i.e., at the 50% inclusion rate). Therefore, it’s important to consider whether to forego the reserve in this transition year and realize the remaining capital gain not yet recognized at the 50% inclusion rate. Individuals should also consider whether a reserve coming into income in a future year will be less than $250,000 (net of any other capital gains or losses expected in that future year) in which case the individual may still be able to benefit from the 50% inclusion rate.
Employee Stock Options
The government has proposed to amend the deduction available to employee stock options to tax a taxable benefit at the same effective rate as capital gains under the proposed change to the inclusion rate. Specifically, the deduction available will now be 33.33% of the taxable benefit (i.e., a 66.67% net inclusion) for taxable benefits realized after June 24, 2024. Further, taxpayers can utilize any portion of the annual $250,000 threshold in place of capital gains to claim a 50% deduction on the taxable benefit (i.e., a 50% net inclusion).
Note that this amended deduction presents uncertainty as to the withholding tax obligation of the employer at exercise of the stock options that generally qualify for the deduction as the employer will not know whether the employee’s taxable benefit is reduced by 50% (if the $250,000 annual limit is utilized) or 33.33%. Until the government provides more clarity, we recommend a more conservative approach—to base the withholding tax on 66.67% of the option income for qualifying stock options after June 24, 2024.
Background on employee stock options
A corporation may grant stock options to their employees as a form of compensation. These stock options typically give the employee the right to acquire a security of their employer at an agreed upon price and date. Stock options granted to an employee may result in a taxable benefit for that employee. The taxable benefit will be calculated as the difference between the fair market value (FMV) of the securities when the employee acquired them and the amount the employee acquired them for (i.e., exercise price). Generally, the taxable benefit is included in the employee’s net income in the same year the options are exercised. However, under certain conditions, the taxable benefit is deferred until the year the employee disposes of the shares. Whether the taxable benefit is included when the options are exercised or when the shares are disposed of, there could be a deduction along with the benefit. For example, where the option was granted at an exercise price of at least the FMV of the shares at grant, and the shares subject to the options qualified as prescribed shares, the deduction will be 50% of the taxable benefit. This allows the benefit to be taxed at the same effective rate as capital gains.
The information contained herein is general in nature and is based on proposals that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice or an opinion provided by Doane Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, specific circumstances or needs and may require consideration of other factors not described herein.
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