Changes to the Capital Gains Inclusion Rate

Transition Rules Can Lead to Excessive CDA Designations

Ben Derakhshani
6/14/2024

On June 10th, 2024, a Notice of Ways and Means Motion was released to amend the Income Tax Act as a follow-up to the increase in capital gains inclusion rate proposed by the 2024 Federal Budget.

This article discusses certain anomalies particularly with respect to potential excessive CDA elections that require close consideration and careful planning, particularly for clients who are looking to crystallize the 50% inclusion rate before June 25, 2024, as there could be unexpected adverse tax consequences.

Given the complexity of the new amendments, we recommend, if possible, to avoid triggering any gains or losses for the period between June 25, 2024, and the taxpayer’s year-end. Where loss planning is absolutely required, the 5 potential scenarios below are helpful to review in order to avoid unnecessary excessive CDA elections.

*Period 1: Before June 25th, 2024
*Period 2: On or after June 25th, 2024


Scenario 1 -  Net capital gain in both Period 1 and Period 2 / or / Net capital loss in both Period 1 and Period 2

Where net capital gains (or net capital losses) are realized in Period 1 and Period 2, the inclusion rate for the tax year is averaged when the June 25th date falls within a taxpayer’s year-end.

For example, assume $100 of net capital gains are realized in Period 1 and $100 of net capital gains are realized in Period 2. The capital gains inclusion rate for a particular tax year would be averaged based on the inclusion rate applicable when the gain is realized (Table 1)

 

In this case, the average inclusion rate would be equal to 58.33% (($100 * 50% IR) + ($100*66.67% IR) / ($100+$100)) and thus, the taxable capital gain for the year would be $116.67.

There is an underlying issue when CDA is paid. Assume the same example as above but a CDA is paid immediately after triggering the gain in Period 1 of $50 ($100 capital gain less the taxable portion of $50). Since the average inclusion rate can only be determined at the end of the year, this could potentially create an overpayment of CDA since the actual CDA addition using the average inclusion rate for the year would amount to $41.67. In the present scenario, an excessive CDA election is made of $8.33 which would be subject to a penalty of 60% of the excessive amount.

Having said that, in a transition year, it could be relatively impossible to determine the non-taxable portion of capital gains. In order to avoid any unexpected results, it is highly advised that in the course of crystallizing the 50% inclusion rate for your clients, that no additional gains or losses are to be triggered in Period 2, particularly if a CDA has already been paid before in Period 1 or a CDA payout is planned in Period 2. Otherwise, it is best to wait until year-end to pay CDA only when it can be relatively certain that no other gains/losses would be triggered.


Scenario 2 – Net capital gain in Period 1 exceeds net capital loss in Period 2

Where the net capital gains realized in Period 1 exceeds the net capital losses in Period 2, the inclusion rate for the year is ½, or 50%.

For example, assume $100 of net capital gains are realized in Period 1 and $20 of net capital losses are realized in Period 2. The capital gains inclusion rate for that particular tax year would be ½ since the net capital gains in Period 1 exceeds the net capital losses in Period 2 (Table 2).

 

In this scenario, the CDA should be paid before the losses are realized in Period 2. A corporation could trigger the gains in period 1 of $100 and realize an inclusion rate of 50% and thus pay out $50 out of its CDA since the CDA balance is determined at any given time. However, if a corporation waits until its year end to pay out a CDA when losses are realized in Period 2, the potential trap is that the CDA reduction due to the capital losses realized should be determined using the inclusion rate of 50% rather than 1/3. As a result, an excessive CDA could potentially be paid of $3.33 subject to a penalty of 60% of the excessive amount.


Scenario 3 – Net capital loss in Period 1 exceeds net capital gain in Period 2

Where the net capital losses realized before in Period 1 exceeds the net capital gains realized in Period 2, the inclusion rate for the year is ½, or 50%.

For example, assume $100 of net capital losses are realized in Period 1 and $20 of net capital gains are realized in Period 2. The capital gains inclusion rate for that particular tax year would be ½ (Table 3).

  

In this scenario, no excessive CDA can result since the there would be no CDA balance available to pay out to the shareholders in the first place.


Scenario 4 –  Net capital gain in Period 1 is less than net capital loss in Period 2

Where the net capital gains realized in Period 1 is less than the net capital losses realized in Period 2, the inclusion rate for the year is 2/3, or 66.67%.

For example, assume $20 of net capital gains are realized in Period 1 and $100 of net capital losses are realized in Period 2. The capital gains inclusion rate for that particular tax year would be 2/3 (Table 4).

  

In this scenario, an excessive CDA can result if CDA is paid based on the inclusion rate at the time the property is sold without consideration to the new amendments introduced. In essence, the non-taxable portion of the gain (i.e. CDA addition) realized in Period 1, would be equal to 1/3. This would result in an excessive CDA election by $3.33.


Scenario 5 – Net capital losses in Period 1 is less than net capital gain in Period 2

Where the net capital losses realized in Period 1 is less than the net capital gains realized in Period 2, the inclusion rate for the year is 2/3, or 66.67%.

For example, assume $20 of net capital losses are realized in Period 1 and $100 of net capital gains are realized in Period 2. The capital gains inclusion rate for that particular tax year would be 2/3 (Table 5).

  

In this scenario, no excessive CDA can result since the CDA would theoretically be paid at year-end.


Strategies to consider

In the course of administrating securities portfolio (and other assets on which latent capital gains and losses exist), we recommend 3 distinct strategies. Other strategies could be contemplated, but the proposed strategies below should provide for a “safer” approach to lowering the risk of excessive CDA elections.

Strategy 1 – Crystallize and “do nothing”

This strategy involves triggering gains in Period 1 and doing nothing for Period 2. Since the net capital gains in Period 1 will be greater than the net capital losses in Period 2 (i.e. Scenario 2), the 50% inclusion rate will be in effect for the particular taxation year. In addition, Scenario 1 should not apply since no gains would be triggered in Period 2.

Strategy 2 – Crystallize and “manage” loss trading

This strategy involves triggering gains in Period 1 and, if necessary for loss planning purposes, triggering losses in Period 2. The losses triggered in Period 2 should never be equal to or greater than the gains triggered in Period 1. Under this strategy, the inclusion rate of 50% will be in effect for the particular taxation year (i.e. Scenario 2).

Strategy 3 – Crystallize and “continue” actively trading

This strategy involves triggering gains in Period 1 and, if it is not ideal to halt trading in a portfolio, limiting any CDA payments to 1/3 (or 33.33%) of any gains realized. Since the CDA blended rate (i.e. Scenario 1) can never be below 1/3, no excessive election could be made. The remaining balance could then be paid out at year-end once all trading closes and the inclusion rate can be determined with accuracy.

 

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