Tax Insights: Finance releases draft legislation to increase the capital gains inclusion rate

In brief

On June 10, 2024, the Department of Finance released a backgrounder¹ that contains additional design details for the federal government’s 2024 budget measure that proposed to increase the capital gains inclusion rate from ½ to ⅔ for capital gains realized after June 24, 2024. However, for an individual, a graduated rate estate (GRE)² or a qualified disability trust (QDT),³ the taxable capital gain will be reduced so that the effective capital gains inclusion rate is ½ on the first $250,000 of capital gains earned in the year; this $250,000 threshold will not be prorated for 2024.

Draft legislation (with no accompanying explanatory notes) in respect of many of these details was included in a Notice of Ways and Means Motion (NWMM) that was tabled in the House of Commons on the same day. However, the government also stated that updated draft legislation (with further technical changes) will be released in late July 2024.

This Tax Insights provides an overview of the main features of this proposed measure to increase the capital gains inclusion rate.

In detail

Capital gains inclusion rate and $250,000 threshold for individuals and certain trusts

For capital gains realized after June 24, 2024, the capital gains inclusion rate will be ⅔, except that for individuals, GREs and QDTs, the taxable capital gain will be reduced so that the effective capital gains inclusion rate will be ½ on the first $250,000 of capital gains earned in the year. The $250,000 threshold will apply to net capital gains realized by an individual (or a GRE or QDT), either directly or indirectly via a partnership or trust.

Transition year

For tax years that begin before June 25, 2024 and end after June 24, 2024, two different capital gains inclusion rates will apply. As a result, taxpayers will be required to separately identify capital gains and losses realized:

• before June 25, 2024 (Period 1)
• after June 24, 2024 (Period 2)

Gains and losses from the same period will first be netted against each other. A net gain (loss) will arise if gains (losses) from one period exceed losses (gains) from that same period. Taxpayers will be subject to the higher inclusion rate in respect of their net gains arising in Period 2 (excluding the portion that does not exceed the $250,000 threshold in the case of individuals, GREs and QDTs), to the extent that these net gains are not offset by a net loss incurred in Period 1.

The annual $250,000 threshold for individuals, GREs and QDTs will be fully available in 2024 (i.e. it will not be prorated), and will apply in respect of net capital gains realized in Period 2, less any net capital loss from Period 1.

Employee stock option deduction

To maintain the treatment of employee stock option benefits as generally equivalent to capital gains, the employee stock option deduction is being reduced from ½ to ⅓ for taxable benefits realized after June 24, 2024.⁴ However, they will be eligible for the ½ rate in combination with capital gains up to a combined annual limit of $250,000. When the total of employee stock option benefits and capital gains exceeds $250,000 in a particular year, taxpayers will be allowed to choose how the ½ rate is allocated between them.

Net capital losses

Consistent with current rules, net capital losses may be carried back three years and forward indefinitely to offset capital gains of other years. Adjustments will be made, however, to reflect the applicable capital gains inclusion rate. This means that a capital loss realized in a year will still fully offset an equivalent capital gain realized in another year during which a different inclusion rate applies.

Allowable business investment losses (ABILs)

An ABIL (e.g. ½  of the capital loss from a disposition to an arm’s length person of shares or debts of a small business corporation) may be used to offset income from any source and may be carried back three years and forward ten years. Any unused portion of an ABIL after 10 years reverts to an ordinary net capital loss, meaning that it can then be carried forward indefinitely, but can only be used to offset capital gains.

The deductible portion of an ABIL will increase from ½ to ⅔ for losses realized after June 24, 2024. However, unlike net capital losses carried over to other years, ABILs will not be adjusted to account for the inclusion rate that applies in the year the loss is claimed. As such, an ABIL realized after June 24, 2024 will be determined by reference to the new ⅔ inclusion rate, even if carried back and applied in any of the three previous years.

Capital gains reserves

In some cases, a taxpayer may receive portions of the payment from the sale of a capital property over a number of years. In those circumstances, a portion of the capital gain may be deferred and recognized for tax purposes over up to the following four taxation years. The portion of the gain that is deferred is referred to as a capital gains reserve. When the deferred portion is recognized as a capital gain (“brought out of reserve”) in a subsequent year, it is included in income at the inclusion rate applicable for that subsequent year.

For taxation years that include June 25, 2024, the amount of capital gain that is brought out of reserve will be deemed to be a capital gain of the taxpayer from a disposition of property on the first day of the taxpayer's taxation year, for the purpose of determining the inclusion rate. For example, any capital gain brought out of reserve in a taxpayer’s taxation year that:

• begins before June 25, 2024 and ends after June 24, 2024, will be subject to the ½ inclusion rate
• begins after June 24, 2024, will be subject to the ⅔ inclusion rate

Partnership allocations

A partnership computes the amount of its taxable capital gain, allowable capital loss or ABIL for a disposition in a fiscal period and allocates these amounts to its partners for that period based on the partnership agreement.

Transitional rules will apply when a taxpayer is a member of a partnership that has a fiscal period beginning before June 25, 2024 and ending after June 24, 2024. In this case, the amount of each capital gain, capital loss and business investment loss (not its taxable capital gain, allowable capital loss or ABIL) will be allocated to the taxpayer and deemed to be a capital gain, capital loss or business investment loss of the taxpayer for the period (either Period 1 or Period 2) in which the disposition of the relevant capital property occurred.

A partnership will be required to disclose to its partners in prescribed form the amount of capital gains, capital losses or business investment losses allocated to the partners that are attributable to dispositions of property in each period. (It is interesting to note that, unlike for trusts [see below], the transitional rules for partnerships do not deem a partnership’s capital gains to have been realized in Period 2 if the partnership fails to disclose the required information.)

Each partner that is an individual (or qualifying trust) will be able to use their annual $250,000 threshold for capital gains allocated by the partnership.

Trust designations in respect of taxable capital gains

A trust resident in Canada can designate any part of its net taxable capital gains for a year (generally, its aggregate taxable capital gains less its allowable capital losses for the year) to one or more Canadian-resident beneficiaries of the trust.

Transitional rules will apply for the taxation year of a trust that begins before June 25, 2024 and ends after June 24, 2024. A trust will designate the amount of the net capital gain (not its net taxable capital gain) and the portion of that amount referable to the trust’s dispositions of property in each period will be deemed to be a capital gain realized by the beneficiary in that period.

Trusts will be required to disclose to their beneficiaries in prescribed form the portion of the capital gains that relates to dispositions of property that occurred in each period. If a trust does not disclose this information, the capital gains will be deemed to have been realized in Period 2.

Commercial trusts (i.e. trusts that are not personal trusts), such as mutual fund trusts, will have the option to elect that the capital gains allocated to investors for the year have been realized by them proportionally within the two periods, based on the number of days in each period.

Each beneficiary that is an individual (or qualifying trust) will be able to use their annual $250,000 threshold for capital gains designated by the trust.

Foreign affiliates and hybrid surplus

The increase to the capital gains inclusion rate from ½ to ⅔ will apply for the purpose of computing the foreign accrual property income of a foreign affiliate of a taxpayer resident in Canada, in respect of capital gains and losses on dispositions of certain property (most commonly, property that is not "excluded property"). In addition, various rules that apply to foreign affiliates will also be amended, including rules relating to the deduction available to corporations resident in Canada in respect of dividends received out of a foreign affiliate's hybrid surplus (i.e. generally, capital gains and losses in respect of dispositions of shares of other foreign affiliates and partnership interests that qualify as excluded property of the foreign affiliate).

A corporation resident in Canada that receives dividends out of a foreign affiliate's hybrid surplus, relating to capital gains and losses in respect of dispositions occurring during:

• Period 1, will continue to be eligible for a ½ deduction when the dividend is received after June 24, 2024
• Period 2, will instead be entitled to a deduction equal to ⅓ of the amount of the dividend

Taxpayers will be required to separately track hybrid surplus relating to capital gains and losses in respect of dispositions by their foreign affiliates occurring during Period 1 and Period 2. However, it is unclear whether this tracking will be done through a separate surplus account. It is also unclear whether separate tracking will be required for the purposes of the foreign tax deduction in respect of hybrid surplus amounts for each period. Legislation in respect of this aspect is not included in the NWMM.

Non-resident dispositions of taxable Canadian property

A non‑resident of Canada is generally subject to Canadian tax on capital gains from dispositions of taxable Canadian property. Absent a certificate of compliance in respect of the disposition, the purchaser of the taxable Canadian property is required to withhold a percentage of the proceeds from the non‑resident.

To reflect the higher capital gains inclusion rate, the withholding rate that applies to a non-resident disposition of taxable Canadian property will increase from 25% to 35%, for dispositions that occur after December 31, 2024. This is because the required withholding is intended to approximate the combined federal and provincial/territorial tax payable by an individual on a capital gain.

Other items to consider

Capital dividend account (CDA) balances

The non-taxable portion of capital gains (less the non‑allowable portion of capital losses) realized by certain corporations can generally be paid to Canadian‑resident shareholders free of additional tax, as a “capital dividend.”  The tracking of this amount (together with other related amounts) is maintained through a notional account referred to as the corporation’s CDA. The proposed change to the capital gains inclusion rate will therefore affect the calculation of CDA. The transitional rules that apply for taxation years that begin before June 25, 2024 and end after June 24, 2024 determine the non‑taxable (non‑allowable) portion of capital gains (losses) using an effective inclusion rate for the year. As the legislation in the NWMM is currently drafted, in certain cases, this approach could result in a CDA balance that is lower than expected.

For example, it is possible that the CDA increase in respect of capital gains realized before June 25, 2024 might be less than ½ of the gain, to the extent that the corporation realizes other gains or losses in the year after June 24, 2024. A corporation in that situation might have inadvertently declared an excessive capital dividend that could trigger penalties (or the retroactive treatment of a portion of the dividend as a taxable dividend, to avoid a penalty), including capital dividends that were declared before the release of the NWMM. The Department of Finance is aware of this concern and is considering whether changes will be required to the draft legislation to address this issue. Until these changes, if any, are announced, a corporation planning to declare a capital dividend should carefully consider the potential impact of the NWMM provisions on its CDA balance.

The takeaway

It is unclear when the federal government intends to introduce the parliamentary bill to implement the changes to the capital gains inclusion rate and related measures. The Department of Finance’s backgrounder states that updated draft legislation will be made available at the end of July 2024; that legislation will presumably cover any related measures that are missing from the June 10, 2024 release, as well as technical changes to fix the provisions included in the NWMM, based on comments that Finance receives from stakeholders. The backgrounder states that these changes are not expected to significantly affect the design of this capital gains inclusion rate measure.

<sup>1. Department of Finance, Backgrounder “Capital Gains Inclusion Rate” (June 10, 2024) at www.canada.ca/en/department-finance/news/backgrounders.html
2. A GRE is an estate that is a testamentary trust, for the first 36 months after the date of death of an individual taxpayer.
3. A QDT is a testamentary trust established for beneficiaries who are eligible for the disability tax credit if certain conditions are met.
4. For more information, see our Tax Insights “Will stock options continue to be an effective form of employee compensation?.“</sup>