After taking a couple months off to add some additional credentials to our repertoire, we are back! A lot has happened and there could be some big potential changes coming down the pipeline. We have reverted back into lock-downs due to a fear of a 4th wave, booster shots have become available, we had what by most measures was an irrelevant election, and inflation is still a constant concern.
But hey, life is interesting, right?
For years now, the narrative that the rich aren’t paying their fair share of taxes has been pushed. Several ideas and tax changes have been tabled that would try to make the tax regime “more fair”. Canada already has one the highest marginal tax rates in the world with the highest potential marginal tax rate being 54% in Nova Scotia. However, one of the proposed changes that some politicians have been pushing for is an increase in the capital gains inclusion rate.
Below we look at a history of capital gains tax in Canada, what capital gains are and how they’re calculated, and lastly what an increase in the inclusion rate would mean for you.
The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least possible amount of hissing.
Jean-Baptiste Colbert
History of Capital Gains Tax in Canada
The origins of capital gains tax in Canada can be traced back to 1962. The recommendation to implement capital gains tax was originally presented in 1966. At the time it was considered a radical reform. It wasn’t until 1969 that the government officially proposed the implementation of capital gains tax.
The original idea was that a portion or all of the capital gains realized would be included in income and taxed at the marginal tax rate. This was dependent on the nature of the asset. A reason for the capital gains tax was so that it would increase the portion of the wealthy individual’s total income which was taxed. They could then reduce the extremely high-income tax rates at the time (80%).
After the 1969 proposal, it took another 3 years until capital gains finally became taxable in Canada. There was a valuation day (commonly referred to as v-day) in 1972. Any accrued capital gains prior to v-day were exempt from taxes.
When capital gains were first imposed, they were implemented with a 50% inclusion rate. This means that if you bought something for $50,000, and later sold it for $75,000, you would have a $25,000 capital gain, of which only 50% is taxable ($12,500).
The inclusion rate remained the same until 1988 when it was increased to 66.67%. Then just two short years later in 1990, it was increased to 75%. Any prior unrealized gains did not get taxed at the previous 50% rate. All realized gains were now taxed at 75% regardless of when they accrued.
The inclusion rate was reduced a decade later in 2000 back down to 66.67%. Then later in the fall of 2000, it was further reduced back to 50% where it currently sits.
How is Capital Gains Tax Calculated?
Generally speaking, capital gains tax is only applicable on the disposition of capital property (there are some exceptions to this that we will see below). This means that if you purchase capital property, you do not have to pay tax on the gain in value as the value accrues. Only when that property is deemed to have been disposed of.
Before you can calculate the amount of tax payable on the disposition of capital property, you first need to calculate the capital gain. To do this you take the proceeds of disposition, subtract the adjusted costs base (ACB) and any cost incurred in selling the property.
The proceeds of disposition are generally equal to the fair market value of the capital property sold (there are some exceptions to this, like selling property to a non-arms-length individual, however, this gets quite complicated and we won’t include it here).
The adjusted cost base (ACB) is generally the purchase price of the capital property plus any expenses to acquire that property.
Example:
We have a piece of farmland. It was purchased 15 years ago for the purchase price of $145,000 with additional expenses of $5,000 to purchase it. I know that if I want to sell the land I can get $500,000 and I will incur expenses of $5,000.
If I sell the land taking everything above into account, how much of a taxable capital gain will there be?
Proceeds of disposition – ACB – Selling Expenses incurred = Capital Gain
$500,000 – ($145,000 + $5,000) – $5,000) = $345,000
So there is a $345,000 capital gain, of which, only 50% of it is taxable. This means that there will be a taxable capital gain of $172,500. Assuming no capital losses (see below) to apply against the gain, the $172,500 would be added to my taxable income in the year it is realized.
Assuming I have no other income in the year of the sale, my federal tax payable would be as follows:
- 15% on the first $49,020 = $7,353
- 20.5% on the next $49,020 = $10,049.10
- 26% on the next $53,939 = $14,024.15
- 29% on the last $29,521 = $5,951.09
- Total federal tax payable = $37,377.34
Capital Losses
There is also the potential that when you sell capital property, it is sold for less than the ACB. If this is the case, it would be deemed a capital loss. Half of the capital losses can be deducted, however, only against capital gains. If there are no capital gains to apply the capital loss against in the year the loss is realized, the loss can be carried back 3 years or carried forward indefinitely.
Life Time Capital Gains Exemption
In 1985, the government introduced the Life Time Capital Gains Exemption. The goal was fivefold:
- Encourage risk taking in small and large businesses,
- Assist Farmers,
- Improve financial health and balance sheets of Canadian companies,
- Provide a tax environment conductive to technology companies raising capital, and
- Encourage Canadians to start businesses.
The exemption was to be cumulative and to offset capital gains realized throughout an individual’s life.
It was originally introduced at $500,000 and after some fluctuations, through the years the 2021 LCGE is $892,218. For longevity sake, we won’t go into more detail on this but for more information, you can click here. However, it is important to note that qualified farming and fishing property actually has a higher limit of $1,000,000.
If we go back to our example above, we see that we had a $345,000 capital gain. This capital gain could be offset by the lifetime capital gains exemption. It is also important to note that although there may be no capital gains tax payable a person may still be subject to Alternative Minimum Tax.
Tax Consequence of Increase Inclusion Rate
Now that we understand capital gains and applicable taxes a little more let’s look at what increasing the inclusion rate would look like.
The math is fairly simple. Let’s say that the inclusion rate is 75% instead of 50% and apply that to our example above.
Our taxable capital gain goes from $172,500 to $258,750 ($345,000 * 75%). Our tax payable now goes from $37,377.34 to:
- 15% on the first $49,020 = $7,353
- 20.5% on the next $49,020 = $10,049.10
- 26% on the next $53,939 = $14,024.15
- 29% on the next $64,533 = $18,714.57
- 33% on the last $42,239 = $13,938.87
- Total federal tax payable = $64,079.69
That’s an additional $26,702.35 of tax payable. Although this is seemingly great for the government because it just generated a whole lot more tax revenue, it could be detrimental to the economy.
Additional Negatives of Increase Capital Gains Inclusion
The increased tax liability that would come with raising the inclusion rate will have several negatives. Yes, capital gains are taxed more favorably than dividend or interest income. However, there is the misconception that increasing capital gains inclusion will only affect the people who are already wealthy. This is not the case. Especially if other proposed tax measures like eliminating the principal residence exemption are implemented as well.
Capital gains tax isn’t just for the ultra-wealthy who have hoards of non-registered investments. It is applied to farmers and business owners. By receiving capital gains it likely means you took some form of a risk with your money. A reward for that risk is paying slightly less tax. If you remove that reward or even make it a disincentive you now make taking those business risks far less appealing.
People will be more reluctant to start a business, invest in other businesses, and develop the economy in general. People will look to find alternative investments opportunities and one of the worst-case scenarios would be large-scale capital flight. If you don’t think higher taxes have that effect just look at the capital flight from California.
The taxation of capital gains also doesn’t show all the years of potential struggle or take into account the time it took to build that capital gain. In our original example that $355,000 capital gain took 15 years to develop. However, it was all taxed as if it was earned in 1 year. The tax consequences of $355,000 taxed over 15 years would look a whole lot different.
Conclusion
Increasing the capital gains inclusion rate, although it could create $8 billion in new tax revenue, could have serious consequences. A decrease in business startups, business investments, and overall economic development. It could result in large-scale capital flight. It seems that those pushing for a higher inclusion rate are forgetting why capital gains are taxed somewhat favorably in the first place.
These negative consequences could be exacerbated if other potential changes are implemented like removing the principal residence exemption and implementing a wealth tax. Stay tuned for a future article on both of these topics.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy
