Defending Your Assets Against a Capital Gains Inclusion Rate Increase

Canadian investors are eagerly awaiting the release of the 2021-2022 federal budget. Since the onset of the COVID-19 pandemic, the Canadian government has committed to nearly unprecedented stimulus in order to keep the economy afloat while supporting lockdown initiatives. This strategy will result in the largest single-year budgetary deficit since Canada began keeping track in 1966-67: $381.6 billion. For context, the 2019 federal deficit was $21.7 billion and the pre-pandemic projection for 2020-21 was $34.4 billion.

The federal debt burden will climb to $1.2 trillion by March 2021, bringing the federal debt-to-GDP ratio to 50.7% compared to the pre-pandemic projection of 30.1%. Many have compared this pandemic to a war. In the aftermath of WW1 and WW2, Canada raised taxes to deal with deficits and a ballooning debt burden. While the current low interest rate environment makes this debt burden more manageable, the government will need to increase tax revenues in the coming years to shrink the debt-to-GDP ratio.   

Although the government has different levers at its disposal to raise tax revenue, we believe that the capital gains inclusion rate is most likely to be affected. The minority Liberals can count on the support of both the NDP and the Greens for an increase in the capital gains tax. Currently, only 50% of eligible capital gains are subject to taxes, making capital gains more tax-efficient than either dividends or interest income. In the last federal election, the NDP campaigned on increasing the capital gains inclusion rate to 75 per cent in order to combat this tax advantage that benefits Canada’s highest earners.  

The latest income tax statistics indicate that only 10% of the 28.5 million personal tax returns filed that year reported any taxable capital gains. Of the $37 billion in taxable capital gains reported, over 75% of the gains were earned by the 10% of taxpayers with income over $100,000, while 55% of the total gains were realized by the one per cent of taxpayers with income over $250,000. A capital gains inclusion rate increase would be largely consistent with the Liberal campaign promise to avoid tax increases on the middle class while asking Canada’s highest earners to pay more.

In a real estate context, the increase in the capital gains inclusion rate may have a profound impact on the returns of an asset. Consider the following example: an investor owns a $20,000,000 property which was purchased for $7,000,000 ten years ago. At today’s inclusion rate, an owner looking to sell this asset would have to pay their marginal tax rate on 50% of the $13,000,000 gain ($6,500,000). In comparison, a 75% inclusion rate would require the owner to pay their marginal tax rate on $9,750,000. Assuming a top marginal tax rate of 53.53%, the tax burden on this sale will be $3,479,450 under a 50% inclusion rate, $4,638,803 under a 66.66% inclusion rate, and $5,219,175 under a 75% inclusion rate. In this example, an inclusion rate increase will reduce the investor’s return on investment by up to 25%, depending on annual yields.

There are various approaches that one can take to protect their assets in the wake of a capital gains inclusion rate increase. The most obvious solution would be to sell your assets and lock-in a capital gains tax bill at the current 50 per cent inclusion rate. In our example, the asset will have to generate an 8.7% after-tax return to offset the increased tax burden associated with a potential 75% inclusion rate in a year’s time. This required return can vary depending on the cost base of an asset and an owner’s marginal tax rate.

If the federal government does increase the inclusion rate, there will not be any forewarning, and it will immediately take effect once the budget is released in March. With that being said, if you had no aspirations of selling an asset prior to the increase, this approach will not make sense. For these individuals, there are several other strategies that may be employed such as reducing one’s capital gains reserve or crystalizing a capital gain through transferring assets to a corporation. We recommend that you speak with your accountant or tax professional to discuss optionality. Ultimately, savvy investors should consider the implications of a capital gains inclusion rate increase and protect their assets accordingly.