Going back nearly 50 years, we can trace the initial start of the taxation of capital gains. When capital gains were first introduced, individuals with capital property would have valued their property — this Valuation Day is often referred to as “V-Day.” For individuals who owned publicly traded shares, the V-Day was Dec. 22, 1971. For other capital property, such as a rental real estate property, the V-Day was Dec. 31, 1971.
To soften the introduction of capital gains, a $100,000 capital gains deduction exemption was introduced. On Feb. 22, 1994, this $100,000 capital gains deduction exemption was repealed. The only capital gains that are eligible for the capital gains deduction limit now are those that arise from dispositions of qualified small business corporation shares and qualified farm or fishing property.
Excluding the possible exemptions, the initial inclusion rate in 1972 was one-half (50 per cent). The inclusion rate has been changed four times since 1972. The purpose of this article is to highlight that these changes all happened quickly and that the implementation of each change was slightly different. When we talk to clients with significant unrealized capital gains, we will always talk about the risk of future changes to the inclusion rate.
This risk should be factored into the decisions made today. In my opinion, this risk is currently higher than in previous years given the current level of federal debt. Before we look at the changes in the capital gains inclusion rate, we will first look at two closely linked countries to see how they are looking at the taxation of capital gains.
In November 2002, the United Kingdom’s Office for Tax Simplification released a report suggesting that the capital gains tax rates should be changed to be consistent with general income tax rates (i.e. on interest income or employment income). The report highlighted how this change could generate additional revenues for the government. This move would effectively double the tax cost of selling an investment with capital gains.
In the United States, the taxation of capital gains is taxed based on how long you have held onto the capital property. For example, short-term capital gains have a higher tax rate than longer-term capital gains. Essentially, if you purchase and sell the asset within one year, it will be taxed at ordinary income tax rates. If you have held an asset longer than a year, then the gains are taxed a favourable rate. To add a little twist into this, Joe Biden has proposed to increase the tax on capital gains, and treat the income as ordinary income, for individuals earning more than US$1 million.
Canada’s first two changes
From 1972 to 1988, the capital gains inclusion rate was steady at one-half (50 per cent). The first change was announced in the 1988 federal budget where the inclusion rate was changed from one-half (50 per cent) to two-thirds (66.7 per cent). Although this announcement was made part way through the year, the change was retroactive to the beginning of the year in which the announcement was made (effectively Jan. 1, 1988). In this same 1988 federal budget, they also announced a second change, which was a further increase to the capital gains inclusion rate to three-quarters (75 per cent). This change was effective on Jan. 1, 1990. Both changes aligned to a taxation year. All capital gains realized after Dec. 31, 1987 and before Jan. 1, 1990 were taxed at two-thirds. Capital gains realized after Dec. 31, 1989 were taxed at three-quarters.
Net capital loss carry-forwards
In the 1988 federal budget, they also added sub-section 111(1.1) dealing with how net capital loss carry-forwards would be applied. Effectively, every time the inclusion rate changes, the net capital loss carry-forward would be adjusted to factor in the new inclusion rates. Fortunately, all these calculations are done by Canada Revenue Agency (CRA). We can view these calculations on behalf of our clients on the “carry-forward” screen within CRA represent a client. If a person has a net capital loss from previous years, the amount that appears on your notice of assessment will factor in the change in inclusion rates, if applicable.
To illustrate, we will use an investor who had $10,000 in capital losses in 1987 when the inclusion rate was 50 per cent. The 1987 notice of assessment would state that the “net capital loss” carry-forward is $5,000 ($10,000 x 50 per cent). The term “net” is a key word to look for when dealing with capital losses to find the amount after the inclusion rate has been applied. Let’s say that this same investor did not realize any gains or losses the next year. The 1988 notice of assessment would state that this same investor has $6,667 ($10,000 x two-thirds) of net capital loss carry-forward as a result of the change in the inclusion rate to two-thirds.
Canada’s last two changes
The 2000 federal budget was announced on Feb. 28, 2000. On this day, the federal government announced the third change to the taxation of capital gains: the inclusion rate would change from three-quarters back to two-thirds, effective immediately on the announcement date of Feb. 28, 2000. On Oct. 18, 2000, the federal government changed the inclusion rate for the fourth time from two-thirds to one-half, once again effective as of the announcement date.
I remember working at a Chartered Accountant’s firm in 2001 preparing the 2000 tax year returns for clients. We had to get trading summaries for all our clients and confirmation slips. This was necessary as the year had three different inclusion rate calculations, as each change announced was immediately effective. If a stock was sold between Jan.1, 2000, to Feb. 27, 2000, the capital gain realized was taxed at the three-quarters inclusion rate. If a stock was sold between Feb. 28, 2000 to Oct. 17, 2000 then the capital gain realized was taxed at the two-thirds inclusion rate, and if a stock was sold on, or after, Oct. 18, 2000 then the capital gain realized would be taxed at one-half.
The capital gains inclusion rate has remained unchanged since the Oct. 18, 2000, fourth change.
Parliamentary changes happen fast
It is worth noting that parliament can change the inclusion rate at any time. They have not historically given us any notice. We have learned from the past that they can make it retroactive. We have never seen them go back to a previous year with respect to changes, only within the current year. We also know that parliament can make a change to the inclusion rate effective immediately. Knowing that these changes happen fast, investors should look at the impact of any potential change and how it would impact their tax liability on unrealized gains.
Stress test a change to the inclusion rate
Capital gains apply to many types of assets. For our clients, capital gains apply primarily on real estate and investment portfolios. Below we will outline a couple of examples (one with real estate and the other with a stock portfolio) of how taxpayers could be impacted by a change to the inclusion rate. We will assume a taxpayer is in the top marginal tax bracket in BC as a result of the capital property disposition. We will also assume that the inclusion rate is adjusted to three-quarters for illustrative purposes only. Three-quarters is the highest inclusion rate we have seen in the past.
Unrealized gains on real estate
A client has owned a principal residence and a rental property, each for more than two decades. The rental property was acquired 21 years ago. The adjusted book value is $120,000. The market value of this property today is $1,150,000. The difference between the market value and the adjusted book cost is a capital gain of $1,030,000 ($1,150,000 less $120,000). If the property was sold with the current inclusion rate of one-half, then 50 per cent of the capital gain, or $515,000 ($1,030,000 x 50 per cent), would be considered the “taxable capital gain”. When dealing with capital gains, the word “taxable” factors in the inclusion rate. The 2021 top marginal tax rate is at 53.5 per cent (20.5 per cent BC plus 33.0 per cent Federal). Assuming the inclusion rate does not change, the taxpayer would have a tax liability of $275,525 ($515,000 x 53.5 per cent) if the rental property was sold.
Lets now assume that the inclusion rate changes to three-quarters, with immediate effect. The capital gain of $1,030,000 would remain the same, but the taxable capital gain would change to $772,500 ($1,030,000 x 75 per cent). The taxpayer would have a tax liability of $413,287.50 ($772,500 x 53.5 per cent). With the parliamentary stroke of a pen, this one taxpayer could end up owing CRA a further $137,762.50 ($413,287.50 less $275,525).
Unrealized gains on non-registered investment portfolio
A client has owned a basket of quality blue chip equity stocks for more than a decade. The client has comfortably lived off pension income and dividends from the investment portfolio. There has been no real need to sell certain holdings. In fact, the gains have been so large that there is reluctance to sell the securities as it would prematurely trigger a tax liability. In some cases, it may result in taxable income rising to the point of upper tax brackets, losing old age security benefits (for clients 65 and older), etc.
Managing risk is an essential part of prudent investment management. The fact that the inclusion rate may change should be factored into decisions. When looking at this client’s portfolio, the unrealized gain was $842,000. Unrealized gain means the difference between the current market value and the adjusted book cost of investments not yet sold. If the investment portfolio was sold, at the one-half (50 per cent) inclusion rate (current rate), the taxable capital gain would be $421,000 ($842,000 x 50 per cent). Assuming the top marginal tax bracket of 53.5 per cent, the tax liability would be $225,235 ($421,000 x 53.5 per cent).
Lets now assume that the inclusion rate changes to three-quarters, with immediate effect. The capital gain of $842,000 would remain the same, but the taxable capital gain would change to $631,500 ($842,000 x 75 per cent). The taxpayer would have a tax liability of $337,852.50 ($631,500 x 53.5 per cent). A change to a three-quarter inclusion rate would result in additional taxes of $112,617.50 ($337,852.50 less $225,235) if the portfolio was sold.
Change in inclusion rate would be like getting hit twice
If the end goal of the government is to collect more tax dollars, then changing the inclusion rate on capital gains would accomplish that goal. Approximately ten years ago, the top marginal tax bracket was 43.7 per cent. Over the past 10 years, provincial and federal tax rates have slowly creeped up, increasing nearly 10 per cent. The increase in tax hikes already creates a greater tax liability for individuals who have deferred realizing taxable capital gains.
It is a relatively easy exercise to do a stress test on a client’s unrealized capital gains. By making different assumptions about tax rates and inclusion rates, we can explain the tax consequences if a fifth change to the inclusion rate is made. The best-case scenario is that the capital gains inclusion rate remains unchanged. The worst-case scenario is that the government continues to increase provincial and federal taxes, and the capital gains inclusion rate increases, resulting in a greater portion of your profits flowing through to CRA — and less in your pocket!
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email firstname.lastname@example.org, or visit greenardgroup.com.