Articles
Proposed Changes to Capital Gains Inclusion Rates
Planning Needed for Canadian Physicians
TL;DR The 2024 Canadian Federal Budget proposes an increase to the capital gains inclusion rate for corporations from 50% to 66.67%. For physicians who invest within a corporation, the proposed changes will increase the amount of capital gains tax on the sale of a corporately owned asset. There also could be implications to the Small Business Deduction Limit and Capital Dividend Account. If approved, the proposed changes will warrant careful planning and the consideration of alternate investing strategies.
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The proposed changes to the capital gains inclusion rates in the 2024 Canadian Federal Budget may have tax implications for incorporated physicians when they sell corporately owned assets.
Let’s explore how the proposed changes may affect Canadian physicians who invest within their holding companies, examining the current inclusion rates, the proposed alterations, and the potential impact.
A Primer on Capital Gains Inclusion Rates
Currently, in Canada, when an individual realizes a capital gain from the sale of an asset, only a portion, known as the capital gains inclusion rate, is included in the physician's individual taxable income.
Right now, the capital gains inclusion rate is 50%. This means that only 50% of the realized capital gain is taxable at the marginal tax rate. For incorporated physicians who invest within their holding companies, any increase to the inclusion rates would increase their tax liabilities.
Investing Within a Holding Company
Incorporated Canadian physicians often utilize holding companies as vehicles for investing and tax planning. Under the guidance of a tax professional, retained earnings (excess profits) from the physician’s medical corporation may be eligible to be transferred to a holding company via a tax-free intercorporate dividend.
The most basic way a physician’s accountant may structure a holding company for a physician, is by making the holding company the owner of the medical corporation and having the physician as the sole owner of the holding company.
Holding companies can hold various assets such as mutual funds, stocks, bonds, real estate, and other investments on behalf of the physician. One of the potential advantages of investing within a holding company is that you have more capital to initially invest in the holding company versus salary or dividends that have been extracted from the holding company and taxed personally. A careful analysis must be made to determine if investing in your holding company is beneficial for you. The principle of tax integration may make the strategy less advantageous in the long run.
What is Tax Integration?
Tax integration is a fundamental principle in the Canadian Income Tax Act that ensures individuals and corporations face similar overall taxation on income regardless of how it is earned. This principle aims to prevent double taxation and promote fairness in the tax system.
Under tax integration, a medical corporation’s earnings are subject to corporate income tax at the applicable rate. When the medical corporation (or holding company) distributes its after-tax earnings to the physician as dividends, those dividends become taxable income. However, to avoid taxing the same income twice, a personal tax credit is provided on a grossed-up amount of the dividend.
Overall, tax integration ensures that when corporate earnings are distributed to shareholders as dividends, the combined corporate and individual taxes paid approximate the tax that would have been paid if the income had been earned directly by the individual shareholder. By aligning the tax treatment of corporate and individual income, tax integration fosters equity and fairness in the tax system, promoting economic efficiency and competitiveness.
Proposed Changes: Impact on Holding Company Investments
The 2024 Canadian Federal Budget proposes changes to the capital gains inclusion rates for individuals and corporations. The proposed changes include increasing the capital gains inclusion rate from 50% to 66.67%. If adopted, this change would come into affect on June 25, 2024.
For individuals, the first $250,000 of capital gain would continue to be taxable at the 50% inclusion rate. Any capital gain above $250,000 would be taxable at the increased 66.67% inclusion rate.
However, for trusts and corporations, including holding companies, all capital gains would be taxable at the new 66.67% inclusion rate. The first $250,000 of capital gain would NOT be taxable at the 50% inclusion rate. The proposed change seems to challenge the fundamental principle of tax integration; an individual and a corporation would not face similar overall taxation on capital gain income.
Let's examine how these proposed changes would affect an incorporated physician who invests within their holding company using a hypothetical example:
Example:
Current Rules
Dr. Rai is an incorporated physician in BC who holds investments within her holding corporation, which receives tax-free intercorporate dividends from her medical corporation. Dr. Rai needs to sell a portion of her investment portfolio, resulting in a realized capital gain of $180,000 in her holding company. Under the current inclusion rate, only 50% of the capital gain, or $90,000, would be subject corporate investment income tax rates.
In BC, the corporate tax rate on investment income is 50.7%, therefore Dr Rai’s tax liability on the $90,000 capital gain would be:
Tax Liability = $90,000 × 50.7% = $45,630.00
Under the current inclusion rate, Dr. Rai's holding company would incur a tax liability of $45,630 on the realized capital gain of $180,000, or 25.35%.
Proposed Rules
Now, let's consider how the proposed changes to the capital gains inclusion rate would impact Dr. Rai's holding company investments as of June 25, 2024.
Using the same example of a $180,000 realized capital gain, under the proposed corporate inclusion rate of 66.67%, the taxable portion would be:
Taxable Capital Gain = $180,000 × 66.67% = $120,006.00
Applying the BC corporate tax rate on investment income of 50.7%, the tax liability on the $120,006 capital gain would be:
Tax Liability = $120,006 × 50.7% = $60,843.04
Therefore, under the proposed regime, Dr. Rai's holding company would incur a tax liability of $60,843.04 on the realized capital gain of $180,000, or 33.8%.
Comparative Analysis
In comparing the two scenarios, it's evident how the proposed changes to the capital gains inclusion rate can impact the tax liabilities of incorporated physicians who invest within their holding companies. Under the current inclusion rate of 50%, Dr. Rai's holding company incurs a tax liability of $45,630 on a $180,000 capital gain. However, under the proposed inclusion rate of 66.67%, the tax liability increases by almost 34%, to $60,843.04 for the same capital gain.
Passive Income and the Small Business Deduction Limit
The proposed increase in the corporate capital gains inclusion rate may also increase the amount of passive income a corporation would report, potentially affecting the small business deduction limit of any connected operating company, like a medical corporation.
The first $500,000 of annual income earned in a medical corporation is taxed at a special low tax rate known as the Small Business Deduction (SBD) limit. In British Columbia, the combined federal and provincial rate is 11%. Income above $500,000 is taxed at the general corporate income tax rate. In British Columbia, the combined federal and provincial rate is 27%.
However, the SBD limit is reduced by $5 for every $1 of passive income made over $50,000 by the medical corporation and any connected corporations in the medical corporation’s fiscal year. Once a medical corporation and its connected companies have made $150,000 of passive income combined, the entire SPD limit is lost, and all income is taxed at the higher general rate.
Reduced Credit Tax-Free Capital Dividend Account
The Capital Dividend Account (CDA) is a notional account that tracks certain non-taxable amounts received by a corporation, such as the non-taxable portion of a capital gains and life insurance proceeds. When a corporation realizes a capital gain, the non-taxable portion is the amount that is not captured under the inclusion rate. Through tax integration, (as described above) the amount is transferred to the CDA and can be paid out to shareholders via a tax-free dividend.
Under the proposed increase to the corporate capital gains inclusion rate, a physician’s medical corporation or holding company that realizes capital gains will have 33.33% of the gain added to CDA versus 50% under the current rules, reducing the amount of tax-free dividend that can be paid out to the physician.
Strategies and Considerations for Incorporated Physicians
Given the potential impact of the proposed changes, incorporated physicians who invest within their holding companies may want to consider the following:
Don’t Panic Sell: It may be tempting to crystalize capital gains at the current lower inclusion rate before June 25, 2024. It would be prudent, however, to see if the proposed change is adopted, and equally prudent to look at the effect of triggering gains now and paying the tax, versus continuing to defer the capital gain for potential growth. If the asset is one that you intend to own for a long time, it may not make sense to crystalize the gains now. Consult with your advisors.
Review Investment Strategies: This is a great time for physicians to review their investment strategies. Exploring tax-efficient investment vehicles and diversification strategies may help mitigate the impact of a higher capital gains inclusion rate.
Personal Tax-Deferred Accounts: Moving forward, physicians may want to consider using tax- deferred accounts such as RRSPs and TFSAs instead of continuing to invest in the holding company structure. This may mean changing the way the incorporated physician is personally paid. Again, careful analysis needs to be done on an individual basis.
Individual Pension Plan: An Individual Pension Plan (IPP) is a corporate retirement savings vehicle available to business owners and incorporated professionals. It is a personal defined benefit pension plan that can offer higher contribution limits than traditional retirement savings options like RRSPs. Careful planning needs to be done to set up an IPP, but the benefit is that investment gains are tax deferred, akin to an RRSP.
Permanent Life Insurance: Corporate and personal tax liabilities would increase with the proposed capital gain inclusion rate changes. Reallocating some of the holding company’s investments into a corporately owned permanent life insurance policy will protect a physician’s estate from tax liabilities, while allowing for the cash value component to grow tax deferred in the holding company.
Conclusion
If adopted, the proposed changes to the capital gains inclusion rate will undoubtedly affect incorporated Canadian physicians who invest within their holding companies. By working with your team of tax and financial advisors to understand the implications of the proposed changes and implement strategic tax planning measures, physicians can safeguard their financial well-being.
Given the potential impact of the proposed changes, incorporated physicians who invest within their holding companies may want to consider the following:
Don’t Panic Sell: It may be tempting to crystalize capital gains at the current lower inclusion rate before June 25, 2024. It would be prudent, however, to see if the proposed change is adopted, and equally prudent to look at the effect of triggering gains now and paying the tax, versus continuing to defer the capital gain for potential growth. If the asset is one that you intend to own for a long time, it may not make sense to crystalize the gains now. Consult with your advisors.
Review Investment Strategies: This is a great time for physicians to review their investment strategies. Exploring tax-efficient investment vehicles and diversification strategies may help mitigate the impact of a higher capital gains inclusion rate.
Personal Tax-Deferred Accounts: Moving forward, physicians may want to consider using tax- deferred accounts such as RRSPs and TFSAs instead of continuing to invest in the holding company structure. This may mean changing the way the incorporated physician is personally paid. Again, careful analysis needs to be done on an individual basis.
Individual Pension Plan: An Individual Pension Plan (IPP) is a corporate retirement savings vehicle available to business owners and incorporated professionals. It is a personal defined benefit pension plan that can offer higher contribution limits than traditional retirement savings options like RRSPs. Careful planning needs to be done to set up an IPP, but the benefit is that investment gains are tax deferred, akin to an RRSP.
Permanent Life Insurance: Corporate and personal tax liabilities would increase with the proposed capital gain inclusion rate changes. Reallocating some of the holding company’s investments into a corporately owned permanent life insurance policy will protect a physician’s estate from tax liabilities, while allowing for the cash value component to grow tax deferred in the holding company.
Conclusion
If adopted, the proposed changes to the capital gains inclusion rate will undoubtedly affect incorporated Canadian physicians who invest within their holding companies. By working with your team of tax and financial advisors to understand the implications of the proposed changes and implement strategic tax planning measures, physicians can safeguard their financial well-being.
To learn more, feel free to book a meeting with Mehul Gandhi.
Mehul Gandhi CFP®, CLU®, TEP
Managing Director, Senior Insurance Advisor - Westmount Wealth Planning Inc.
This information has been prepared by Mehul Gandhi, CFP®, CLU®, TEP who is a Senior Insurance Advisor and Managing Director for Westmount Wealth Planning Inc., and a Financial Planner for Westmount Wealth Management Inc. Westmount Wealth Planning Inc. is a subsidiary of Westmount Wealth Management Inc. Westmount Wealth Management Inc. is registered as a Portfolio Manager in British Columbia, Alberta, and Ontario.
This material is distributed for informational purposes only and is not intended to provide personalized legal, accounting, tax, or specific investment advice. Please speak to a Westmount Wealth Advisor regarding your unique situation.