Will the changes to the capital gains inclusion rate impact me?

Intro Speaker:  

Hello, and welcome to Matters Beyond Wealth with your host, Leanne Kaufman, president and CEO of RBC Royal Trust. For most of us, talking about subjects like aging, late life, and estate planning isn’t easy. That’s why we’re going to help get the conversation started on this podcast while benefiting from the insights and expertise of some of the country’s top experts. We want to bring you information today that will help to protect you and your family in the future. Now, here’s your host, Leanne.

Leanne Kaufman:

It’s mid-June as we record this podcast and the new 2024 federal budget rules increasing the inclusion rate on capital gains are about to be implemented. This is top of mind for many Canadians who may be impacted in a variety of ways. Not only does this affect the taxation of assets that have appreciated in value such as a secondary or vacation property or a farm property, but also on estates and trusts on the death of a taxpayer.

Hello, I’m Leanne Kaufman, and welcome to RBC Wealth Management Canada’s Matters Beyond Wealth. With me today is Prashant Patel, vice president of high net worth planning services at RBC Wealth Management Family Office Services. For over three decades, Prashant has been assisting high-net-worth families with tax, estate, and retirement issues. He’s a certified financial planner, an Associate of the Society of Actuaries, a member of the Society of Trust and Estate Practitioners, and a close colleague of mine.

Prashant, thanks for being here with me today to talk about the impact of the capital gains tax and why this matters beyond wealth.

Prashant Patel:

Thank you, Leanne. It’s good to be here.

Leanne Kaufman:

So, can you start by giving us an overview of the new rules, at least as we understand them here in mid-June with the legislation just having been recently released?

Prashant Patel:

Yeah, sure. So, I think most people are aware that since year 2000, only 50 percent of capital gains are taxable in Canada, and this 50 percent rate is known as the capital gains inclusion rate. However, under the new rules, which the government announced on April 16, 2024, in the federal budget, capital gains realized on or after June 25, 2024, will now have a capital gains inclusion rate of two-thirds. However, the government did say that the first $250,000 of capital gains per year for individuals will still enjoy the 50 percent inclusion rate, and then above $250,000, it will be at the two-thirds inclusion rate.

Now, a couple things related to the $250,000 limit.

• Firstly, for any of our listeners that have employee stock options, those gains will also be at the new two-thirds inclusion rate. However, the $250,000 limit is combined for capital gains and stock option gains.
• Also the $250,000 limit does not apply to capital gains triggered in corporations and most trusts. There are some exceptions for certain trusts, and so [I] just wanted to mention that.
• Then finally, to put the $250,000 limit in perspective, the maximum tax savings in any one year of having this first $250,000 of gains tax at the 50 percent inclusion rate versus the two-thirds inclusion rate is about $22,000.

So Leanne, at a high level, those are the main changes.

Leanne Kaufman:

Now, there’s been a lot of talk in the news about how a very, very small percentage of Canadians will actually be negatively impacted by these changes in the rules, but we know that’s not necessarily the case, especially if someone owns appreciated value, like for example, a secondary residence. Can you talk to us a little bit about that, Prashant?

Prashant Patel:

Yeah. I mean, I think everyone’s situation is different of course. But for certain individuals that have cottages that have appreciated significantly and they’re concerned about these increased tax rates, you have to step back and say is there a possibility

• first of all, that your cottage when it’s sold will have a gain greater than $250,000, well, either on sale or potentially at death when there’s a deemed disposition of all of your assets; and
• secondly, if that cottage is owned jointly with your spouse and assuming the income attribution rules don’t apply, then each spouse can claim their $250,000 limit. Meaning that if only the gain was over $500,000, then it would be subject to this higher two-thirds inclusion rate.

Now, also note that it is possible that you could claim your cottage as your principal residence, meaning that the entire gain would be completely tax-free. Now, of course, a couple can only have one principal residence, so it may be possible that your cottage has a greater capital gain compared to your city home. And so you can claim on the sale of your cottage an unlimited principal residence exemption on the cottage, and then on your city home, maybe you and your spouse can claim the first $250,000 limit at the lower inclusion rate.

So again, these are things where every situation is different. Just keep in mind that there are some exemptions for minimizing the tax on that cottage. And there could be other strategies as well that you may feel that if the cottage is going to appreciate significantly, maybe is now the right time to look at transferring that cottage to your children so that the future growth is not taxed in your name. Now, of course, that transfer to the child will mean that you’ve deemed sold the cottage, which could trigger some tax today, but at least the future gain is not going to be subject to tax upon your death.

So these are things that, again, you need to work with a good team of advisors to ensure that you’re taking all of this into account.

Leanne Kaufman:

So, let’s talk about how the changes specifically impact estates and trusts, and we’ll start with the estates. So, listeners may or may not understand exactly how taxation of estates works, but maybe we could start with the T1D and you could tell us first of all what does that mean, a T1D, and how if at all these changes impact that?

Prashant Patel:

Right. Okay. So at death in Canada, you’re deemed to have disposed of all of your assets, which may trigger a very large capital gain on your final personal tax return, which you referred to as that T1D. Now, this capital gain can be deferred for any assets passing to your spouse or spousal trust. But for some of our listeners, that final capital gain on their tax return at death could be fairly large. And now with the higher capital gains inclusion rate, that’s going to result in a larger tax bill.

Having said that, again the first $250,000 of capital gains on your final tax return would still have that lower 50 percent inclusion rate, and then thereafter it would be at the two-thirds. So I think our listeners will have to consider, for some listeners where there may be a very large capital gain at death, you may need to review your estate plan, maybe look at your life insurance coverage and kind of work with your team advisors related to that.

Leanne Kaufman:

So, the other part of estate taxation is when the estate becomes a trust for tax purposes and then the estate has to start filing T3 returns, which are trust returns. Are the rules any different when you’re looking at a trust versus an estate?

Prashant Patel:

Yeah, they are slightly different. So, there’s this concept after death for the estate, which is referred to as a graduated rate estate or a GRE, and that basically rises when someone dies and there’s an estate, and that estate is considered as a testimony trust for tax purposes.

Now, income earned in a trust, whether it be a trust during your lifetime or a testamentary trust that’s not paid out to the beneficiary is typically taxed at the highest marginal tax rate. However, if the estate is considered as a graduated rate estate or a GRE, and that can only last for 36 months after death, then the income earned in that estate, the GRE, is taxed at the marginal tax rate, at the graduated tax rates like an individual.

So originally when the rules came out on April 16th, it was a bit unclear whether this GRE estate tax return would have the $250,000 limit for the lower inclusion rate. But with the recent legislation that the government released on June 10^th, they did confirm that the GRE estate will have its first $250,000 of capital gains at the lower limit.

Now, when it comes to an ongoing trust, let’s say a testamentary trust in the estate, let’s say you have a trust set up for your child or for a disabled child, in that case then there’s not going to be—well, for a disabled child, there will be a $250,000 limit, it was referred to as a qualified disability trust. But let’s just say that you have a regular ongoing testamentary trust after death for a beneficiary. In that case, the income earned in that trust, if it’s not paid or payable out to the beneficiary, will be taxed at the highest rate and there’s no $250,000 limit.

However, most trusts that we see, they do have the income paid out to the beneficiary. In that case the trust is not taxable and the beneficiary pays the tax, let’s say, on that capital gain, and the beneficiary is eligible for their own $250,000 limit for that lower inclusion rate.

So there was talk that trusts are not going to get $250,000 limit, but there is some clarification. Most trusts will not, but most trusts do distribute the capital gains out, and therefore the beneficiary can use their own $250,000 limit for the lower inclusion rate.

Leanne Kaufman:

So as long as the gain is being passed along to the beneficiary in the year when it is triggered, then it’ll be taxed in the beneficiary’s hands, the beneficiary can take advantage of the $250,000. But if it’s not being paid out, if it’s being held in the trust for some period of time because that’s what the trust says has to be done, then it’ll be taxed at the highest rates and no $250,000 exemption on the gains.

Prashant Patel:

Yeah. Unless it’s a GRE or a qualified disability trust. That’s correct.

Leanne Kaufman:

Right, right. And again, GREs are only the first three years post death in a testamentary trust, right?

Prashant Patel:

Correct.

Leanne Kaufman:

And if it was a trust that someone set up during their lifetime, what we call an inter vivos trust, so wasn’t created under someone’s Will, same rules, right? I mean, there’s no GRE in that example, but the rules around paid or payable to a beneficiary versus taxed in the trust still apply?

Prashant Patel:

Yeah, exactly. So again, most trusts set up during lifetime, they’re going to have the income and capital gains paid or payable or allocated out to that beneficiary before the end of the year, and therefore the beneficiary will pay the tax on that and they can use their $250,000 exemption related to that or limit.

There was some confusion related to 2024, because this is a transition year for capital gains triggered in a trust in 2024 before June 25^th and after the June 25^th. The question is, will the gains before June 25^th be eligible for the 50 percent inclusion rate, which would be unlimited before June 25^th, and gains after June 25^th, would they be subject to the higher inclusion rate? And the government did clarify that to say that the trustee will need to indicate to the beneficiary when they’re filing their 2024 tax return for the capital gains triggered in the trust, if that capital gain was triggered before June 25^th, then the beneficiary would have the lower inclusion rate for that capital gain at the 50 percent inclusion rate. For capital gains triggered after June 25^th in the trust, the beneficiary can claim the first $250,000 at the lower inclusion rate, and then thereafter it would be at the higher inclusion rate. So, 2024 will be a bit of a transition year when it comes to trust and trust distributions.

Leanne Kaufman:

Yeah. A little bit messy in the tax reporting for 2024. I know as trustee, we’re hopeful that the form of tax slip that CRA provides us to then pass on to the beneficiary for their reporting purposes actually allows the boxes to differentiate between the pre and post June 25^th so it’s clearer for beneficiaries how they have to report it on their own personal tax returns.

Prashant Patel:

Yeah, we’re going to have to wait and see for that. Yeah.

Leanne Kaufman:

Yeah. Yeah.

So, one of the types of trusts that we didn’t talk about yet were alter ego trusts, and these are a very specific type of trust under the Income Tax Act. Can you give us just a very high-level overview of what an alter ego trust is and then how the capital gains rules apply in that context?

Prashant Patel:

Yeah, certainly. So, an alter ego trust is set up during lifetime for someone that’s 65 or older.  Typically what they’re going to do is they’re going to take assets that are in their personal name and they’re going to transfer those assets at cost to the alter ego trust. So there’s no tax triggered when you transfer it in. That trust is only—the income earned in that trust and the capital, is only for that individual that’s 65 years or older.

So the question is, why would someone set that up? Well, there’s a number of reasons, but primarily there’s two reasons why someone is transferring assets into an alter ego trust.

• It’s primarily to avoid probate tax in certain provinces like BC and Ontario—it’s fairly high probate.
• And also for privacy reasons. That’s another reason why they may set up that alter ego trust.

Now, if you have a spouse, you can have a trust for you and your spouse referred to as a joint partner trust. And again, it’s kind of similar rules as the alter ego trust.

Now, typically when these trusts are set up for tax purposes, although income is generated in that trust for tax purposes, the income is reported on the individual’s tax return and the trust really doesn’t pay any tax on that. So, in that case, again, that individual, given that that capital gain was reported on their personal tax return, again, the first $250,000 of that is going to be at the lower inclusion rate and thereafter at the higher inclusion rate.

The only difference is going to be at death. Because at death, those trusts are deemed to have disposed of all of their assets. In that case, in the year of death, the capital gain is actually taxed within the trust. It’s not taxed on their personal tax return like it was during their lifetime, and therefore that’s going to be taxed at the highest rate and there will be no $250,000 limit because it’s not—as we said before—a graduated rate estate or a qualified disability trust. It’s going to be taxed at the two-thirds inclusion rate for any capital gains.

Leanne Kaufman:

Complicated rules. You really need some advice around how to do these tax filings, I think.

Prashant, I also know there were some changes to the exemption levels relative to capital gains. Can you talk to us about what those exemptions were?

Prashant Patel:

Yeah, so probably referring to a business owner—

Leanne Kaufman:

Right.

Prashant Patel:

—That when they sell the shares of their business—assuming that it’s a qualified Canadian private, active business—then every shareholder regardless of age, every Canadian resident can get the first million dollars roughly tax-free on that capital gain. So, the government in the federal budget of 2024 decided to increase that capital gains exemption to $1.25 million for capital gains on the sale of the qualified business on or after June 25^th of 2024.

So, I think what this change means—good news—I think it means that it’s going to be really important for business owners to take a close look at their corporate structure to see, is it structured in such a way that when there or if there’s a future sale in the future that they can take advantage of this higher capital gains exemption. Also there’s an ability if it’s structured properly, typically using a family trust, to potentially multiply that capital gains exemption with family members, spouse, children, even grandchildren.

So again, very important to work with a good team of advisors, accountant, lawyer. We’ve got a lot of specialists on our team, on the family office services team at RBC, and we do a lot of this type of planning with our business owner clients.

Leanne Kaufman:

Yeah, and that’s invaluable advice when the rules are as complicated as these ones are and changing rapidly as we try to go through 2024.

Well Prashant, if you hope listeners can just take one thing away from the conversation you and I have had because it is a complicated one, what might that one thing be?

Prashant Patel:

Well, there is a lot of concern that these changes are going to impact a lot of people in Canada, and I think you have to assume that you really have to look at your own situation.

• For many Canadians, their capital gain is going to be on an annual basis under the $250,000 limit, and therefore it’s almost like status quo.
• And in many cases, if you own assets jointly with your spouse and assuming these income attribution rules don’t apply, then you get to double that $250,000 limit, so it’s really $500,000.
• So again, there are some people though with cottages and farmland that possibly may exceed that limit, even though they may not be considered the wealthy.

It’s really important to look at what assets you have, is there going to be a sale of that asset during your lifetime, or will there be a large capital gain at death, and really work with a good team of advisors to plan for potentially strategies around minimizing that capital gain at either during your lifetime or death to hopefully maybe take advantage of that $250,000 limit, or for the business owner the capital gains exemption, and hopefully minimize that tax down the road.

Leanne Kaufman:

Yeah, great advice. Thanks, Prashant for joining me today to talk about the impact of the new capital gains inclusion rates on estates, trusts, and property like the family cottage or family farm and why all of this matters beyond wealth.

Prashant Patel:

Great. Thank you, Leanne.

Leanne Kaufman:

You can find out more about Prashant Patel at rbcwealthmanagement.com. If you enjoyed this episode and you’d like to help support the podcast, please share it with others, post about it on social media, or leave a rating and review. Until next time, I’m Leanne Kaufman. Thank you for joining us.

Outro speaker:

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