The proposed 2024 Federal Budget includes a few business-friendly measures. However, the most contentious change is an increase in the capital gains inclusion rate from one-half to two-thirds. Depending on the province, this represents an increase in the tax rate on capital gains from 24% to 27%, to a range of 32% to 36%, at the highest marginal rates, subject to a $250,000 safe harbour that maintains the one-half inclusion rate for individuals. This safe harbour does not apply to corporations, nor to trusts, except to the extent that rules permit capital gains to flow through to individual beneficiaries of trusts. In short, the new capital gains rate would closely approximate the tax rate for eligible dividends.

The proposed increase to capital gains rates has drawn sharp criticism not only from the business community and other stakeholders such as the Canadian Medical Association, but also from two former Liberal ministers of finance, various Premiers, and economic policy commentators. The proposed change to the capital gains rate is slated to take effect on June 25, 2024. At the time of writing this article, no draft legislation is publicly available. At the same time, many taxpayers are faced with a decision to act before June 25, such as triggering capital gains before that time, but such decisions will be made in the face of some uncertainty given that the tax rules have not yet been released and might not be released until June 25.

Sale of a Business

In our experience, the majority of business sales are completed as share sale transactions, other than in certain industries (e.g. real estate) or certain “main street businesses” with a price of, say, less than $1 million. If a transaction is in play, one question that will come up will be whether to push for a closing before June 25 or delay the closing until after June 25. The answer will depend on several factors, including the following:

• whether the vendor’s shares and corporation whose shares are being sold qualify for the capital gains exemption, which currently has a lifetime limit of $1,016,836 per person, but is proposed to increase to $1,250,000 on June 25;
• various details of the corporate structure, such as the existence of a holding corporation (a “Holdco”) that will realize capital gains without access to the $250,000 safe harbour for the existing inclusion rate, or a family trust in which beneficiaries can utilize a capital gains exemption;
• the potential for a pre-closing reorganization utilizing a valuable tax pool known as “safe income” to reduce or defer the capital gains tax (see summary below) or other tax pools such as loss carry forwards;
• whether the deal terms include an earn-out, vendor financing, or similar deferred payments;
• the potential for alternative minimum tax (“AMT”) which is essentially a pre-payment of tax where an individual has received tax-advantaged income as a result of claiming a capital gains exemption, among other things;
• the purchase price, considered in conjunction with the factors above and other planning considerations.

Accessing a capital gains exemption will be more crucial than ever if the Budget proposals are enacted. Under existing rules and rates, a capital gains exemption is worth up to $240,000 of cash savings for a shareholder resident in Alberta (or if a trust is a shareholder, potentially $240,000 for each beneficiary of the trust). After June 25, with the increased capital gains rate combined with the increase in the lifetime capital gains exemption limit to $1,250,000, the cash tax savings balloons to as much as $400,000 per person, ignoring the $250,000 safe harbour, and subject to an analysis of AMT.

If the transaction is an asset sale by a corporate vendor, in many cases it would be advantageous to close before June 25, but again, there may be individual circumstances that would suggest otherwise.

Asset Protection, Purifying Corporations for Sale, and Safe Income

Often, a corporation will not satisfy the balance sheet tests required for the shareholders to qualify for a capital gains exemption. This occurs when a significant portion of the asset value is not comprised of assets used in an active business (e.g. investments or excess cash). In those situations, the corporation must be “purified” by removing such redundant assets to qualify for the capital gains exemption, provided that the assets can be transferred without triggering a tax liability that outweighs the benefits of the capital gains exemption.

Prudent tax planning may allow for excess cash or investments to be moved to a Holdco, either fully or partially tax-deferred, provided that a corporation has sufficient safe income. Safe income is a tax calculation that can be relatively simple or extremely complex and time-consuming, depending on the history of the corporation. Oversimplified, it represents tax-paid retained earnings that are attributable to a certain class of shares or shareholders. Safe income can be moved between connected corporations on a tax-deferred basis through a pre-closing corporate reorganization, or potentially by a transaction as simple as a dividend to a Holdco, depending on the structure and circumstances. To the extent that the corporation does not have enough safe income, the excess may be taxed as a capital gain where it might otherwise be a tax-deferred dividend to a Holdco.

Safe income represents an amount that allows for a tax-deferred extraction of corporate surplus, most often by way of an inter-corporate dividend or share redemption. In addition to being used for purification before a share sale, it can also be used to capitalize retained earnings and reduce the capital gain on shares held by a Holdco, even where there are no redundant assets to remove from the corporation. Safe income is also useful for corporate asset protection by removing excess cash out of harm’s way from non-consensual creditors (e.g. a plaintiff in a lawsuit).

In general, the safe income rules under section 55 of the Income Tax Act aim to prevent the conversion of taxable capital gains to tax-deferred dividends. Safe income will become an even more valuable tax pool as the capital gains rate is increased. Historically, the downside of not having enough safe income would be an integrated tax rate of approximately 28% (using Alberta rates) compared to a capital gains rate of approximately 24%, ignoring the time value of money. For the uninitiated, an “integrated” tax rate refers to the combined corporate tax and personal tax that would ultimately be borne by an individual shareholder when receiving a dividend. Going forward, assuming the 2024 Budget proposals are enacted, the downside of having insufficient safe income (or inaccurately estimated safe income) would be closer to 34.4% for a Canadian-controlled private corporation in Alberta, on an integrated basis, ignoring the time value of money and any interest or penalties. In many situations, it would be valuable to maintain up-to-date safe income calculations, given its importance for purification, asset protection, and tax deferral.

Death of a Taxpayer

There is a double tax problem – or in some cases, a triple tax problem – when a person passes away owning shares of a private corporation. There is a deemed disposition on death, resulting in a capital gains tax on the shares of the private corporation. If the capital gains exemption is not available (which is often the case if the deceased shareholder had previously exited the active business), the tax rate on the deemed disposition would be up to 24% in Alberta. When the corporation pays dividends to the estate or heirs, the dividends can be taxed at a rate of up to 42% for non-eligible dividends, for an integrated tax rate of up to 66%. In the absence of tax planning, even at existing capital gains rates, a deceased shareholder or their heirs can effectively become a minority partner in the economic value of corporate assets, with the majority partner being the government.

The proposed increase to the capital gains rate will further tilt the mix in favour of the governments (federal and provincial), assuming the increase applies to the deemed disposition on death. Governments may have, for example, up to a 74% interest in the accretive value of the private corporation through capital gains and distributive taxes, while the estate has just a 26% interest. This ignores the $250,000 safe harbour for the lower inclusion rate but does not change the principle that the government can take more of the family wealth than the family. Triple tax can occur if capital gains arise on the sale of corporate assets, further reducing the value of the estate.

Fortunately, tax planning is available to mitigate these punitive tax outcomes. During a shareholder’s lifetime, an appropriately managed estate freeze can reduce the double tax problem. Common post-mortem tax planning techniques include subsection 164(6) loss carry backs and 88(1)(d) “bump” transactions to reduce the corporate tax on certain assets (e.g. land and securities). These planning techniques are often time-sensitive, and obviously can be expected to have even greater importance under an augmented capital gains regime.

Leaving Canada

Over the past several years, we have seen many clients emigrate from Canada to the United States or other countries. This is often driven by family, business or employment opportunities, or lifestyle choices, but the tax burden in Canada is frequently a significant factor in making the decision. To paraphrase former Liberal Finance Minster John Manley’s comments in a recent interview, “when the government becomes the senior partner in an individual’s economic relationship, then… you may encourage them to move elsewhere…”

A common misperception is that a person must sell all of their assets when ceasing to be a Canadian resident. While it is important to break residential ties with Canada, it is not the case that all assets must literally be sold, particularly when immigrating to a country that has a tax treaty with Canada. However, there is an exit tax that is similar in principle to death tax. For tax purposes, a person leaving Canada has a deemed disposition of most of their assets. There are various exclusions such as life insurance and RRSPs, but for a person who owns shares of a private company, there will often be a significant capital gain on this deemed disposition. There are various strategies to mitigate or defer this capital gains tax, including posting security with Canada Revenue Agency (“CRA”) as one example. For some people contemplating a departure, it may be prudent to realize, or “crystallize,” capital gains before June 25, especially if the deemed capital gains are expected to exceed the $250,000 safe harbour.

Qualified Farm Property

The proposed change to the inclusion rate will also affect many farm families and their succession planning efforts, especially those who are currently going through a farm transition. When farm property is disposed of, capital gains may arise by virtue of actual or deemed dispositions. The impact of the higher inclusion rate will likely be felt when capital assets of the farm are sold. This includes farmland, buildings, grain bins, quota, or other machinery and equipment. Whether the farm is looking to sell or divest its main assets or make a lifetime gift, there may be a significant capital gain that could be subject to the proposed inclusion rate. Moreover, because of this higher tax bill, the next generation will have a harder time buying out their parents and taking over the operation.

Family farms are “asset rich, cash poor.” The proposed changes to the inclusion rate present yet another hurdle for producers to contend with. An augmented capital gains tax regime will make intergenerational farm transfers a lot more burdensome, but, with proper guidance and advice, there are ways to defer capital gains, ease the tax load, and set up the family farm for continued success. If farmers and ranchers are thinking about crystallizing capital gains prior to June 25, they should also consider any potential tax consequences that could outweigh the benefit of triggering the premature capital gain. This is especially true since, as noted above, the Budget also proposes to increase the lifetime capital gains exemption with indexation resuming in 2026. Accordingly, thoughtful tax advice should be sought with respect to navigating these changes in a way that minimizes the tax burden on the operation and the family.

Crystallizing Capital Gains Before June 25

In some situations, it might be prudent to crystallize capital gains before June 25, especially for assets held in a corporation. For marketable securities, this could be as simple as selling assets. For less liquid assets, full or partial capital gains could be realized by transferring assets to another corporation and filing a tax election under section 85 of the Income Tax Act, as one possible method of crystallization.

Any crystallization strategy should only be done with careful tax advice, including a consideration of the AMT rules.

A Caution on Retroactive Tax Planning and Backdating

Given the uncertainty of the upcoming changes to the capital gains rules, it may be tempting to wait for the legislation and backdate or “effective date” a transaction (such as a crystallization) as of some date prior to June 25 once the details of the rules are known. This would be a risky approach. If there was no clearly documented intent as to the nature and details of the transaction before June 25, the CRA may accuse the taxpayer of fraud, or carrying out an incomplete or improperly implemented transaction. On that basis, the CRA may apply the increased capital gains rate and potentially impose penalties for fraud or gross negligence. As such, tax advice should be sought and, if desired, a tax plan should be completed well in advance of the June 25 coming-into-force date.

Preparing for the Capital Gains Tax Change

In navigating the uncertainty of the proposed changes to the capital gains rate, taxpayers, particularly business owners, face a complex landscape of strategic decisions and considerations. This summary has outlined a few of the considerations, but there are other aspects of the 2024 Budget that are not discussed here, but may be relevant, such as the new employee ownership trust rules and the Canadian Entrepreneurs Incentive.

With the looming implementation date of June 25, 2024, proactive tax planning becomes paramount. From triggering capital gains before the rate increase to navigating business sales, protecting assets, and planning for the future, individuals and businesses must carefully weigh their options. Moreover, the risks associated with retroactive tax planning underscore the importance of seeking timely advice and making informed decisions. As the deadline approaches, thoughtful and timely action can help mitigate tax liabilities and position taxpayers for greater financial resilience in the face of these significant changes to Canadian tax policy. 

If you have questions, please reach out to Rob Worthington, Rob Rakochey or any member of Field Law's Tax Group for assistance.