As outlined in our publication, Capital Gains Tax Update: What You Need to Know Now, effective June 25, 2024, the capital gains inclusion rate has increased from one-half to two-thirds for corporations and trusts, and from one-half to two-thirds on the portion of capital gains realized annually in excess of $250,000 for individuals.1 The impact of the proposed increase in the capital gains inclusion rate can be significant, resulting in a higher tax rate of 8 – 9% for corporations, trusts, and individuals at the top marginal tax rate. (For details, please refer to the Tax Rate Summary Charts by Province/Territory in the Appendix).
This measure will impact many individuals with significant unexercised stock options or large accrued gains on capital assets (such as securities, real estate, or shares of private businesses). The deemed disposition occurring at death will cause the realization of capital gains which could exceed the $250,000 threshold for many individuals (where the spousal/common-law partner rollover is not available). In addition, since the $250,000 threshold is not available to corporations, many investment holding companies, professional corporations or other incorporated businesses holding investment assets will be impacted by the increased tax rates on capital gains income. This article highlights some key implications of an increased capital gains inclusion rate to individual and corporate taxpayers and considers some potential planning considerations involving life insurance for those impacted.
Individuals
As noted previously, unlike other taxpayers (such as corporations and most trusts), individuals will be allowed a $250,000 threshold below which the capital gains inclusion rate will remain at the former 50% rate. Given the availability of this annual $250,000 threshold, many individuals will be able to avoid the proposed higher inclusion rate by timing their dispositions to stay below this threshold each year, or by effectively splitting income with other family members who will each be eligible for their own $250,000 threshold (subject to the relevant income attribution and Tax on Split Income (TOSI) rules, etc.).
Although the increase in the capital gains inclusion rate will primarily impact the wealthiest Canadians, many families with significant accrued gains on secondary real estate properties – such as cottages or rental properties – may also be impacted (where the principal residence exemption, or annual $250,000 threshold, is not otherwise available).
In addition, for Canadian income tax purposes, when an individual dies they are deemed to dispose of their capital properties and to have received proceeds equal to Fair Market Value (“FMV”) immediately prior to death. However, where assets are transferred or bequeathed to a surviving spouse or common-law partner, the assets are deemed to have transferred at their cost amount, thereby providing for a default tax-deferred “rollover” of the assets to the surviving spouse/common-law partner. However, where there is no surviving spouse/common-law partner, or on the death of the survivor, many Canadians of modest wealth may realize significant capital gains at death (in excess of their $250,000 threshold) thereby triggering a higher income tax liability on their terminal (final) return. A higher death tax liability, based on the increased 2/3 inclusion rate, could have important ramifications for the estate plans of many Canadians, impacting insurance planning and introducing liquidity concerns, which were predicated on the previous 50% capital gains inclusion rate.
This one-time realization of a large capital gain at death could cause the higher 2/3 capital gains inclusion rate to apply to many average Canadians. Individuals with a shortened life expectancy – particularly those without a spouse or common-law partner – may therefore wish to consider planning to spread accrued capital gains to access their annual $250,000 threshold over multiple years, through sale or accelerated (taxable) transfers or bequests of property during their lifetime to family members.
Life Insurance
Permanent life insurance – such as whole life and universal life – provides coverage for long-term needs that are ongoing, evolving and of a permanent nature, such as estate preservation, business succession planning, supplementing retirement income, income tax reduction, and paying one’s final taxes and estate settlement costs. Since the recent increase in the capital gains inclusion rate could impose a higher tax liability at death for many Canadians, (permanent) life insurance can be an effective and tax-efficient source of funding to cover this potentially higher death tax liability. Those with a spouse/common-law partner may be able to reduce the costs of insurance by purchasing a joint second-to-die policy, which pays out on the second death when the funds are needed. The use of life insurance can also assist with the preservation of important family assets (such as a cottage) which otherwise may have required liquidation to pay the associated death taxes.
Corporations
Corporations earning capital gains, such as investment holding companies and professional corporations, are expected to be negatively impacted by the increase in the capital gains inclusion rate in several ways, as follows:
-
No $250,000 threshold
Unlike individuals, corporations do not have an annual $250,000 threshold and will therefore be subject to the higher 2/3 capital gains rate on all capital gains realized on or after June 25, 2024.
-
Capital Dividend Account (CDA)
Although the specific details are currently uncertain, it is expected that the addition to the CDA – which allows for the tax-free flow-through of certain non-taxable amounts to shareholders of private corporations – will decrease following the corresponding increase to the capital gains inclusion rate.
-
Integration
The “integration” system for Canadian-Controlled Private Corporations (CCPCs), that seeks to make an individual indifferent between earning investment income personally, or indirectly through a corporation, will be negatively impacted by the proposed higher inclusion rate. Specifically, it is expected that there will be a higher ultimate tax cost of earning capital gains through a corporate structure, particularly where the individual would otherwise be subject to the lower 50% capital gains inclusion rate (below the $250,000 threshold).
-
Small Business Deduction (SBD)
CCPCs accessing the SBD and earning investment income – such as professional corporations – may be subject to a ‘claw back’ of the SBD by $5 for every $1 of passive investment income above a $50,000 threshold. Since the taxable portion of capital gains will increase due to the higher inclusion rate, it is likely that the current asset allocation will result in many (professional) corporations reaching this $50,000 taxable income threshold earlier, potentially resulting in a reduction in the SBD.
As a result, a review of the investment and asset allocation decisions may be warranted for many corporations, and shareholders may consider a withdrawal (or wind-up) of corporate investments, subject to the potential corporate and personal tax costs of distribution.
Life Insurance
As noted above, permanent life insurance can provide coverage for long-term needs that are ongoing, evolving and of a permanent nature for individuals, but can also be effective – and in some cases, even more effective – when held in a corporation. Since the recent increase in the capital gains inclusion rate will impose a higher tax liability on all capital gains realized corporately, (permanent) life insurance can be an effective and tax-efficient strategy for private corporations in many situations, such as:
-
Corporate asset transfer
Involves the purchase of a permanent life insurance policy from corporate funds otherwise invested in long-term fixed income investments, to reduce the corporate tax on investment income. Eventually, when the death benefit is paid, it will be received by the corporation tax-free and the amount that exceeds the adjusted cost basis (ACB) of the policy can be paid to heirs tax-free, through the company’s CDA.
-
Preserve small business deduction
Corporations earning significant investment income are potentially subject to the clawback of the small business deduction and will be negatively impacted by the higher capital gains inclusion rate. These corporations may benefit from reallocating investments in a taxable portfolio to a permanent life insurance policy as an alternative corporate investment strategy, to avoid the possible loss or reduction in the SBD and to access the tax-sheltering advantages of life insurance.
-
Lower after-tax corporate dollars
Generally, life insurance premiums are not deductible for income tax purposes, unless the insurance policy is used as collateral for a loan. However, using corporate earnings – that are taxed at lower corporate rates compared to more costly personal after-tax dollars – is a more cost-effective way to fund non-deductible business expenses such as life insurance, as less pre-tax income is needed to cover the expense. This strategy can create efficiency in funding the permanent insurance solution to provide tax-free liquidity and help subsidize the estate and tax liabilities.
Life insurance as an investment
The increase in the capital gains inclusion rate has considerably reduced the discrepancy in the top marginal tax rates for individuals on investment income. Specifically, as noted in Chart 1 in the Appendix, the top marginal tax rate on capital gains will now increase from approximately 25%, to 35%, in most provinces and territories, which is similar to the top marginal tax rate on eligible dividends (which varies widely, but averages 35% to 40%), and which could have implications to many investment and asset allocation decisions for top rate taxpayers. The impact to the taxation of investment income is similar in corporations (refer to Chart 2), and is further distorted by the breakdown in the “integration” system noted previously.
As such, both individuals and corporations may wish to consider the purchase of (permanent) life insurance as an alternative asset class. Permanent participating life insurance policies have provided attractive returns for more than a century. Over the long run, they have delivered more favourable returns than traditional investments such as GICs, bonds, and other fixed income vehicles with lower volatility.
For individuals, three key advantages of an “Individual Investment Shelter” strategy include:
-
Cash value accumulates in the investment portion, but is not taxed as long as it stays in the policy.
-
Beneficiaries get the full value of the policy. Both the initial insurance and growth are theirs tax-free.
-
Benefits can go straight to beneficiaries – generally avoiding probate costs, estate fees, and settlement delays.
In the corporate context, a “Corporate Investment Shelter” strategy provides the following benefits:
-
HoldCo reallocates excess assets to a permanent life insurance policy and the policy fund is invested to match the asset allocation objectives.
-
The policy fund grows tax-deferred during a lifetime (there is no tax on growth).
-
Upon the death of the insured/shareholder, the policy pays HoldCo a tax-free death benefit, and allows some or all of the proceeds to be paid out as a tax-free capital dividend to the heirs.
Conclusion
The Federal government’s recent tabling of the Notice of Ways and Means Motion began the process of formally implementing the measures announced in the 2024 Federal Budget to increase the capital gains inclusion rate. Although further technical amendments are forthcoming with the release of updated draft legislation this summer, future changes are not expected to materially affect the design or introduce new features to this measure, which will have significant implications to many taxpayers, both for short-term planning in 2024 and over the long-term. In particular, the recent increase in the capital gains inclusion rate to 2/3 will impact the estate plans of many Canadians, potentially resulting in higher taxes at death, and possible liquidity concerns which may affect the preservation of key family assets. Similarly, these changes will impact all corporations earning capital gains income, and the broader “integration” system affecting private corporations. As a result, Canadians reviewing the potential implications to their particular situation may wish to consider the role of permanent life insurance to adjust and plan for these impacts.
Consulting with your external advisors for specific advice and direction in your particular situation is essential. For more information, please speak with your BMO Private Wealth professional.
Appendix
Chart 1: 2024 Top Marginal Tax Rates on Capital Gains — Individuals and trusts
Chart 2: 2024 Top Marginal Tax Rates on Capital Gains — Corporations
1 The Ministère des Finances du Québec announced that Quebec intends to amend its legislation to align with these Federal changes to the capital gains inclusion rate.
BMO Private Wealth provides this publication for informational purposes only and it is not and should not be construed as professional advice to any individual. The information contained in this publication is based on material believed to be reliable at the time of publication, but BMO Private Wealth cannot guarantee the information is accurate or complete. Individuals should contact their BMO representative for professional advice regarding their personal circumstances and/or financial position. The comments included in this publication are not intended to be a definitive analysis of tax applicability or trust and estates law. The comments are general in nature and professional advice regarding an individual’s particular tax position should be obtained in respect of any person’s specific circumstances.
