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The change to the capital gains inclusion rate has created distress among those approaching retirement, particularly business owners, who now face a much higher tax bill than they had planned.SrdjanPav/iStockPhoto / Getty Images

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The Liberal government’s proposed change to the capital gains inclusion rate has sent financial advisors, tax professionals and their clients into a tailspin, with business owners approaching retirement especially concerned.

Citing the change as a way to improve tax fairness, the federal government’s recent budget increased the inclusion rate on capital gains for individuals of more than $250,000 a year and all capital gains realized by corporations to two-thirds (67 per cent) from one-half (50 per cent) as of June 25. However, details are scarce as there’s no legislation yet to implement the increase.

This change “is a pretty big shocker,” says Matthew Ardrey, portfolio manager and senior financial planner at TriDelta Private Wealth in Toronto. He notes that capital gains will still be taxed more favourably than interest income, but not by much, so clients may be deterred from taking any additional risk with investments and will need to manage when they take capital gains more carefully.

Furthermore, whole life insurance will now take on a larger role within corporate estate planning, and it becomes more like an investment, Mr. Ardrey says. A private corporation can insure the life of the owner; the annual premiums are paid by the corporation and invested by the insurer and, upon the owner’s death, the insurance funds flow tax-free to the beneficiaries to pay the taxes on the business’s capital gains.

The change also affects a corporation’s capital dividend account (CDA), which is a notional account that “keeps track of various tax-free surpluses accumulated by a private corporation,” according to the Canada Revenue Agency’s website. “These surpluses may be distributed tax-free in the form of capital dividends to the corporation’s Canadian-resident shareholders.”

The most common tax-free amounts included in the CDA are the tax-free portion of capital gains realized by the corporation, life insurance proceeds on certain policies, and capital dividends received from other corporations.

Now, the amount attributed to the CDA is less because the non-taxable portion of any capitals gains is 33 per cent instead of 50 per cent under the previous rules, Mr. Ardrey says.

The change has created distress among those approaching retirement, particularly business owners, who now face a much higher tax bill than they had planned for if they sell an asset or their company to fund their retirement, Mr. Ardrey says.

“You’re at the finish line and somebody moves it another three kilometres down the road. That’s where a lot of the angst and frustration” is coming from, he says.

Avoid a knee-jerk reaction

The change has “tax advisors’ heads spinning,” says Henry Shew, managing director of tax and senior client advisor at Our Family Office, a full-service family office based in Toronto, with many clients asking what to do.

His first advice to clients is to avoid “a knee-jerk reaction.” First, if it’s an asset or investment the client plans to hold for more than the next five or six years, “then don’t even think about selling,” he says.

“We’re still talking about the time value of money,” Mr. Shaw says, and paying taxes to the government upfront – even if it’s a bit less than in the future – on an asset someone plans to hold for the long term may not be worth it.

Leaving an investment to compound and saving the money that would have gone toward paying taxes today makes sense in most cases, he says. “[Y]ou will probably be better off even if you sell that at a higher [capital gains] inclusion rate.”

But for clients already planning to sell, expediting that process before June 25 could make sense, he adds. That decision also depends on whether the assets are held by an individual or a corporation.

To help people explore whether it’s better to hold onto an asset or sell it before the capital gains inclusion rate increase comes into effect, Mr. Ardrey’s firm, TriDelta Private Wealth, has created an online calculator that factors in the value of the asset, the book value and the rate of growth.

This isn’t the first time Canada’s capital gains inclusion rate surpassed the 50-per-cent level. Taxes on capital gain, which came into effect in 1972 at 50 per cent, rose as high as 75 per cent in 1990. However, it’s been at 50 per cent since 2000.

Some people are weighing their options and wondering if the Liberal government will be in power after the next election or if the Conservatives may roll back this change if they win the next election, says David LePoidevin, senior investment advisor and senior portfolio manager with the LePoidevin Group at Canaccord Genuity Wealth Management.

“We’re rolling the dice that, we’ve seen political landscapes change, but there’s a chance that the government will not be in power and there’s a chance the rate will go back down,” he says.

Jenifer Bartman, founder and principal at Jenifer Bartman Business Advisory Services, says many businesses will try to hold off on a sale of the entire company or pause a transition plan or asset sale in case the rules change in the next few years. “Maybe this [change] will be tweaked or maybe it will be thrown out.”

Business owners need to ensure they have qualified tax, accounting, investment and legal advisors to help them navigate this changing business landscape, particularly with raising funds in an environment with a higher capital gains inclusion rate, Ms. Bartman adds.

For corporations, Mr. LePoidevin is looking at selling assets now that might get sold shortly anyway so business owners pay taxes at the lower rate, bringing those gains forward, then planning to not sell any assets over the next two years while the rate is higher. “There are a lot of unknowns.”

For some elderly people who might pass away before any changes happen and their estate would be beyond the $250,000 threshold, Mr. LePoidevin is exploring selling assets now to crystallize those gains and in, some cases, buy back those investments quickly so the gain upon death is less after the higher inclusion rate comes into effect.

These moves may create a windfall for the government next April when these taxes come due, he notes, as people move transactions forward to save on taxes. Then, revenue from capital gains taxes may wane in the following years.

However, Mr. LePoidevin says investors should not take losses now to offset any gains, as those losses will be worth more after the capital gains changes come into effect.

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