Proposed tax changes to Capital Gains exemptions
On April 16, 2024, the Canadian government delivered the Liberal Party’s fiscal budget with significant changes to capital gains inclusion rates on taxable income. These measures, part of the 2024 Federal Budget, have been described by the government to promote fairness while supporting economic growth and innovation.
One of the key aspects of the 2024 budget is the government’s plan to modify the capital gains tax structure. Namely, increasing the inclusion rate from one-half to two-thirds on capital gains exceeding a $250,000 annual threshold for individuals, and all capital gains realized by corporations, effective June 25, 2024. The foreword of the 416 page budget purports that the proposed changes to Canada’s tax system seeks to ensure that those with higher incomes contribute proportionately more through these new income tax measures.
Adjustment in Capital Gains Taxes
The proposed adjustments to capital gains taxes under the Federal Budget 2024 mark a significant shift from previous capital gains tax laws in Canada. Currently, there is no maximum threshold on the 50% inclusion rate on capital gain income realized annually for individuals, corporations, and trusts. Notably, the inclusion rate for taxation on income derived from capital gains, whether below or above $250,000 is currently set at 50%, such that only half of the capital gains earned for a given taxation year are subject to income taxes.
Under the new proposals, effective June 25, 2024, the inclusion rate will increase from 50% to 66.67% on the amount of the capital gains exceeding $250k for individuals (including capital gains realized personally through a partnership or trust). Therefore, the inclusion rate on the first $250k on capital gains for individuals remains unchanged at 50% of the capital gain subject to taxation, however, 66.67% of the capital gains earned above that $250k threshold during that same taxation year will be subject to taxes.
With respect to capital gains realized by Corporations and Trusts, they would not benefit from the first $250,000 capital gain inclusion rate of 50% offered to individuals, but rather the Federal government intends to increase the inclusion rate on all capital gains realized annually by Corporations and Trusts from one-half to two-thirds, by amending the Income Tax Act and effective on capital gains triggered on or after the June 25, 2024 date.
The department of Finance provides the example of how their proposed changes would affect an individual in Ontario earning a $400k salary and in that same taxation year also has a $300k gain from the sale of a revenue property. Under the current rules, the individual would pay tax on 50% or $150,000 of that capital gain realized on the sale of the property. Under the new proposed rules, for that same gain, that same individual would now pay tax on $158,333 of the gain. Calculated as follows, $125,000 (1/2 x $250,000) plus the gain above the $250k threshold, being $50k, multiplied by the new inclusion rate of two/thirds (66.7%) equaling $33,333. As the individual in this example is in the highest income tax bracket, the proposed change would cost this individual $4,461 more in provincial and federal income tax for the subject taxation year.
Increase to Lifetime Capital Gains Exemption
The lifetime capital gains exemption, which previously allowed Canadians to exempt up to $1,016,836 in capital gains tax-free on the sale of their small business shares, will be raised to $1.25 million, effective from June 25, 2024, with ongoing indexation to inflation after 2025. This increase expands the scope of tax relief available to Canadians with eligible capital gains below $2.25 million, providing enhanced benefits compared to previous exemptions.
Incentives for Entrepreneurs – Canadian Entrepreneur Incentive
The 2024 budget proposes the rollout of the Canadian Entrepreneurs’ Incentive. This incentive reduces the inclusion rate of taxable capital gain income to 33.3% (vs. current 50% for individuals) for a lifetime maximum of $2 million in eligible capital gains. The maximum limit for the reduced inclusion rate of 33.3% will increase by $200k each year starting in 2025, until it reaches the $2 million lifetime maximum for entrepreneurs under this incentive in 2034.
Of note, the Canadian Entrepreneurs Incentive can be combined with the increased Lifetime Capital Gains Exemption of $1.25M. Therefore, each year until 2034, the Canadian entrepreneur will be able to benefit from total capital gain tax exemptions ($1.25M indexed for inflation) in combination with partial exemptions up to the maximum amount for the taxation year of the capital gain under the Canadian Entrepreneurs’ Incentive.
For example, pursuant to the Budget 2024, in 2029 the lifetime maximum under the Canadian Entrepreneurs’ Incentive will be set at $1M, therefore, an individual in 2029, who has not used their Lifetime Capital Gains Exemption will benefit from at least $2.25M in total and partial lifetime capital gains exemptions ($1.25M total exemption per Lifetime Capital Gains Exemption + limited 33.3% inclusion of the $1M Maximum via the Canadian Entrepreneurs’ Incentive). Thus, the taxable income on a capital gain of $2.25 million for an eligible entrepreneur using their Lifetime Capital Gains Exemption would be reduced to $333k ($1M unexempt Capital Gain x 33.3%) vs. $500k taxable income under the current system.
Once the government initiative has been fully implemented, entrepreneurs will benefit from a combined exemption of at least $3.25 million when selling all or part of a business. For entrepreneurs to benefit from this incentive, it will only be available to:
- founding investors in certain sectors who own at least 10 per cent of shares in their business, and
- where the company has been their principal employment for at least five years.
A taxpayer wishing to claim the exemption under this incentive on capital gains realized on the sale of their shares of a corporation must respect the following conditions to qualify:
- The share(s) must be of a small business corporation under Income Tax Act, owned directly by claimant at sale.
- Throughout the 24-month period prior to the sale, the shares must be of a Canadian-Controlled Private Corporation (CCPC) with over 50% of assets used in active business in Canada.
- The tax-payer claiming the exemption was a founding investor at the time the corporation was initially capitalized, holding their shares for at least 5 years prior to the sale.
- The claimant must own over 10% of the fair market value of the corporation’s capital stock and voting rights from initial subscription until sale.
- The claimant must be actively engaged in business activities for 5 years before sale.
- Shares cannot represent interest in a professional corporation, reputation-based corporation, or certain business sectors (financial, insurance, real estate, food and accommodation, arts, recreation, or entertainment sector).
- Share must be obtained for fair market value consideration.
In summary, should the individual entrepreneur fall within the criteria to benefit from the incentive, income realized on capital gains, after maxing out Lifetime Capital Gains Exemption for the taxation year, would be subject to tax on 33.3% of the eligible taxable gain up to a maximum of $2m (in 2034).
The example advanced by the department of finance describes an individual who has already used their total lifetime capital gains exemption of $1.25M in a past sale of shares of their small business. They are now selling their remaining shares in their business and earn $2 million in capital gains on the sale. Under the current provisions of the Income Tax Act, the individual would pay tax on $1 million (i.e. 50% of the $ 2 million in capital gains). When the Canadian Entrepreneurs’ Incentive is fully implanted in 2034, the individual, failing under the proposed eligibility criteria, would only pay tax on 33.3% of the capital gain or $667k (vs. $1 Million), thereby reducing their taxable income by $333k when selling the shares of their business.
Capital Gains on Residential Property
In the 2024 budget, the government reaffirms its commitment to maintaining exemptions for capital gains from the sale of principal residences, ensuring that Canadians are not taxed on home sales.
To further discourage property flipping and encourage homeownership, capital gains from properties bought and sold within one year have been treated as business income since January 1, 2023.
Conclusion
The proposed changes to capital gains taxes outlined in 2024 federal budget will have significant implications for individuals, corporations, trusts, and entrepreneurs across Canada. It is important for affected parties to understand these changes and prepare accordingly to navigate the evolving tax landscape.
For individuals, particularly those with substantial capital gains, the increase in the inclusion rate to two-thirds for gains exceeding $250,000 annually means a higher portion of their investment income will be subject to taxation. This adjustment may require individuals to reassess their corporate structures, investment strategies and financial planning to optimize tax outcomes.
Similarly, corporations and trusts will also be impacted by the higher inclusion rate on capital gains, potentially affecting investment decisions and financial reporting. Entities should review their capital gains exposure and consult with their legal and tax advisors to manage the implications of these changes effectively.
Entrepreneurs stand to benefit from the expanded lifetime capital gains exemption and the introduction of the Canadian Entrepreneurs’ Incentive. These measures provide increased tax relief for founders and investors, supporting innovation and business growth. By taking advantage of these incentives, entrepreneurs can leverage the opportunities presented by the evolving tax landscape to optimize their financial positions and drive economic growth.
As these changes come into effect on June 25, 2024, individuals, corporations, trusts, and entrepreneurs should take proactive steps to prepare for the impact on their tax liabilities and investment strategies. A taxpayer may wish to consider transactions to trigger unrealized capital gains before the effective date while they can still benefit from the lower inclusion rate. This may include seeking legal and professional tax advice, reviewing investment portfolios, and adjusting business plans to align with the new tax regime.
Ultimately, understanding and adapting to these changes will be crucial for individuals and entities to navigate the evolving tax landscape and optimize their financial outcomes under the 2024 budget’s revised capital gains tax framework. By staying informed and proactive, taxpayers can effectively manage their tax obligations and capitalize on available incentives to support financial goals and business success.
Links
https://budget.canada.ca/2024/report-rapport/chap8-en.html
https://budget.canada.ca/2024/report-rapport/tm-mf-en.pdf
