MONTHLY MARKET MUSINGS

June 2024

The Upcoming Increase In The Capital Gains Inclusion Rate

“We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.” - Winston Churchill

The announcement of the 2024 Federal Budget in April included some surprising proposed changes to the capital gains inclusion rate for both Canadian corporations and Canadian citizens. The capital gains inclusion rate currently sits at 50% but on June 25th, 2024, it will increase to roughly 66.67% for both individuals and corporations. For individuals, the higher inclusion rate applies to any capital gains in excess of $250,000 annually while for corporations there is no exempted amount. These changes have led many people to wonder whether it makes sense for them to crystallize their portfolio gains at the current lower rate prior to the increase at the end of June.
 

These changes essentially would result in investors with more than $250,000 in gains having to pay about 33.3% more capital gains tax for those in the highest marginal tax rate bracket.[1] The Canadian government estimated that only about 44,000 Canadians would be directly impacted by these changes but the increase will indirectly affect a much larger number of Canadians than that. Many have pointed out that this estimate severely misjudges the eventual impact on the population. The estimate appears to be focused on wealthy individuals with gains in excess of $250,000 in their investment portfolios but seems to overlook the fact that many people tend to have a "lump sum-type" capital gain within their lifetime - typically from the sale of a cottage/second home/rental property, etc. This estimated impact also ignores the second derivative implications on Canadian corporate profitability which are a critical component to the financial well being of many retired Canadians. From an estate standpoint, a large non-registered portfolio or a second property would also be subject to these changes as well during an estate settlement.

For those with capital losses, these can still be carried forward indefinitely. It is expected that the inclusion rate applied to the capital gain will be the same as the inclusion rate of the offsetting capital loss. This is regardless of whether the losses stem from prior years when the inclusion rate was lower. Essentially, gains and losses should always offset each other dollar for dollar.

Do I Sell And Take My Capital Gains At The Lower Inclusion Rate?

The answer to this question depends on a few factors - your ability to spread out your gains to remain below the $250,000 exemption limit, the time horizon of the investments with capital gains, and the possibility of needing large cash withdrawals (above $250,000/year) in the next few years from those investments. If your investments already have or accumulate more than $250,000 in capital gains and you have a long time horizon with no need for immediate cash then we believe remaining invested and not selling is the best course of action. The key reason behind this is that over time the additional capital that would have been paid out as tax will add to returns and eventually surpass the break-even point where the higher inclusion is offset by those additional gains. For the past 50 or so years, the S&P 500 Index has had an average annualized return of about 7.5% or 10.5% when dividends are reinvested.[2] So using a hypothetical expectation of an 8% return on a portfolio, we could expect to break even at about 6 years according to CIBC's tax expert, Jamie Golombek.[3] Thus, investors with a longer time horizon would likely be in a better financial situation by doing nothing (not selling ahead of the June 25th deadline). For those who require cash withdrawals above $250,000 per year and/or have a shorter time horizon, it is worth considering triggering some of those gains prior to the June 25th deadline.

For those earning capital gains within a corporation, the time horizon for the break-even point becomes murkier. We would suggest consulting your accountant in these circumstances as it can become very individualized and more complex given the large number of factors to consider.

The Potential Negative Impact On Corporations And The Markets

The comments above have been focused on the individual impact of one's own personal tax situation but these capital gains inclusion rate changes will also impact the corporate landscape and markets as well. For one, the changes can make equities as an asset class less attractive to investors as the higher tax weighs on the company's profitability. Essentially, if the company pays more taxes on the gains of its capital assets then it has less capital available to return to shareholders via share buybacks, dividend increases or to keep as retained earnings for future investments and growth. This will reduce the appeal of Canadian equities which have struggled for a multitude of reasons to keep pace with the strong profitability of U.S. stocks over the past few decades. Another impact could be seen in the Canadian technology sector, more specifically start-ups, where companies attract and retain much-needed tech talent by offering ownership through stock and stock options in the company. Higher capital gains tax indirectly lowers compensation for these employees within this area and that could be another reason, amongst the many that already exist, for new technology firms to avoid setting up shop in Canada. Similar concerns about the changes being harmful to compensation and disincentivizing work within Canada in an already-strained health care system have been voiced by various others including the Canadian Medical Association and many doctors.[4]   

While significant alarms have been raised with this budgetary proposal, many are still waiting to see the official overall details of the plan which have yet to be released. The proposal itself has been separated from the budget and is a stand-alone bill which will require a vote and is expected to be brought to the House of Commons a few days prior to the summer break.[5] It is worth noting however that, according to media outlets, the changes were included in the 2024 Budget's tax annex and this would suggest that the Canada Revenue Agency (CRA) has the ability to enforce these changes provisionally until the legislation passes.[6]

JAY SMITH, CIM®, FCSI

Senior Portfolio Manager & Senior Wealth Advisor    

jay.smith@cibc.ca

BRAD BROWN, MBA, CFA
Portfolio Manager & Associate Investment Advisor

brad.brown@cibc.com