An article by PPI’s Planning Services team, a group of lawyers, accountants and actuaries who provide tax and estate planning support to Advisors affiliated with PPI.
Effective June 25, 2024, the 2024 Federal Budget in Canada proposed to increase the capital gains inclusion rate to 2/3 from 1/2 for corporations and most trusts* and for individuals for capital gains over $250,000**. This means for individuals and certain trusts, the first $250,000 is at a 1/2 inclusion rate and above $250,000, the inclusion rate is now 2/3. In B.C., the tax rate on capital gains is 26.75% on the first $250,000 but 35.67% over $250,000. This is an 8.92% increase (the other provinces differences range from an increase of 7.92% to 9.13%). The Budget stated that the $250,000 threshold was introduced so that only the wealthy would be affected. Well, this is not the case when someone passes away – the middle class will have their tax liability on their death increase by 33 1/3% for capital gains over $250,000.
On death, a taxpayer is deemed to have disposed of their capital assets at fair market value. This will result in a capital gain where the deemed proceeds exceed the adjusted cost base of the asset. Many clients will have investment portfolios with unrealized gains, rental properties, a family cottage or shares in a private company. Now the gain on these assets is taxed at the 2/3 inclusion rate for capital gains over $250,000. If clients have assets in an alter-ego, spousal/common-law partner or joint spousal/common-law partner trust, there is also a disposition of assets at fair market value on the death of the relevant beneficiary. For the capital gains that arise in these trusts the inclusion rate is 2/3 since these trusts do not get the 1/2 inclusion rate on the first $250,000.
Case Study
Let’s assume that Jane passes away with a cottage that she purchased for $50,000 and that is now worth $1.5 million. She had public securities with a fair market value of $500,000 and a cost base of $150,000. The capital gain on her death would be $1.8 million ($2 million -$200,000). Using B.C.’s highest marginal tax rate, there would be additional tax of $138,260*** to pay on the capital gain as a result of the increased inclusion rate.
Now what if Jane had her own company? The company is an active business and was valued at $5 million on her death. The cost base of her shares is nominal so there is a significant capital gain on her death (Jane is not married so she can’t defer the tax on death by rolling the shares to her spouse on a tax deferred basis). Since the 1/2 inclusion rate on the first $250,000 of capital gains would already be used with her other assets, the full $5 million capital gain would be at the 2/3 inclusion rate resulting in tax of $1,783,500 which is an increase of $446,000! Budget 2024 proposed to increase the lifetime capital gains exemption for qualified small business corporations to $1,250,000 which would reduce the tax liability to $1,337,500 if her company qualified.
Consider Life Insurance
Life insurance is a tax efficient method to fund the tax liability on death and with these budget changes, the use of insurance should be reviewed with your clients to determine if existing insurance coverage needs to be increased or for those that do not have insurance, purchase new insurance.
The postmortem planning that should be completed to avoid double tax on death when a taxpayer owns shares of a private company must also be reviewed for Jane. The use of corporate owned life insurance to eliminate double tax has become even more tax efficient with the increase in the capital gains rates since the gap between the tax rates on capital gains and dividends is narrowing. For more information on the postmortem planning alternatives, please read PPI’s Tax Bulletin, Postmortem Planning Alternatives.
Impact on a Corporation
We have discussed the effect that the increase to the capital gains inclusion rate will have on the assets Jane holds on her death but attention also needs to be drawn to the taxation of capital gains inside her company while she is still alive. As mentioned earlier, corporations do not receive the 1/2 inclusion rate for the first $250,000 of capital gains. This makes earning capital gains in a corporation more costly than if the capital gains were earned personally. Usually, there should not be a difference if an individual earns income directly or through a corporation (that pays a dividend to the individual) – a concept called integration. It is not perfect but is generally achieved. However, with corporations having the 2/3 inclusion for the entire capital gain, the effective tax rate is 12.66% (using B.C. rates) higher for capital gains under $250,000 if earned in a corporation rather than if earned personally.
The other concern is that since Jane’s corporation likely uses the small business deduction, which taxes the active business income in the corporation at favorable rates, the increase in the capital gains inclusion rate will result in the passive income in her corporation growing faster. When there is passive income in a corporation, the amount of income to which the small business deduction may be applied is ground down $5 for every $1 of passive income over $50,000 and completely eliminated for passive income over $150,000 (use the Passive Investment Calculator to determine the impact of the passive investment income inside your corporation). In addition to the benefit of funding the tax liability on death and eliminating double taxation on death, investment income earned inside a corporate owned life insurance policy is not included in determining passive income that grinds the amount of income to which the small business deduction may be applied. This may be another benefit of corporate owned insurance.
With the increased capital inclusion rate, it is a good time to revisit your client’s estate plan and their insurance needs to ensure that they have sufficient coverage to fund the increased tax liability. Contact your local PPI Collaboration Centre.
* The Notice of Ways and Means Motion tabled on June 10, 2024, proposes that, similar to individuals, the 1/2 inclusion rate will continue to apply to the first $250,000 of capital gains in a year for graduated rate estates and qualified disability trusts.
** The capital gain is net of capital losses, capital losses carried forward, the lifetime capital gains exemption, the new Canadian Entrepreneurs Incentive exemption (also announced in the Federal Budget) and the temporary $10 million exemption for transfers of businesses to an Employee Ownership Trust.
*** The tax under the old 1/2inclusion rate would have been $481,500 ($1,800,000*26.75%). The tax under the new 2/3 inclusion rate would be $619,760 (($250,000* 26.75%) + ($1,550,000*35.67%)) for an increase in tax of $138,260 (28.7% increase).
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