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2024 Federal Budget: Crystallizing Accrued Capital Gains Before the Inclusion Rate Changes

May 2, 2024

The 2024 Federal Budget includes a proposal to increase the inclusion rate for capital gains from one-half to two-thirds, effective June 25, 2024. The capital gains inclusion rate is the percentage of a capital gain that you must include in your income for tax purposes, determining how much of the gain you earn from selling an asset (e.g., stocks or property) will be taxed.

Many taxpayers are now wondering whether they should crystallize their accrued capital gains before June 25 to take advantage of the 50% inclusion rate before it’s gone. “Crystallization” means realizing an accrued gain while still retaining ownership of the underlying asset. Note: this article does not discuss the realization of accrued gains on outright sales of assets[1].

The below article is a deep dive into the complex considerations around how and why these factors might influence your decision to crystallize or not; however, we recommend reaching out directly to your DMCL advisor for personalized advice on how the inclusion rate change could impact your situation.

There are several factors to consider in determining whether crystallizing accrued gains is beneficial or not; however, the two most important factors are cashflow and the time value of money.

Cashflow

Crystallizing an accrued gain creates a tax liability that is payable now; however, crystallization transactions generally don’t increase your available cash. So, you must come up with cash to pay the taxes on the crystallized gain.

If you have to borrow money to pay the taxes, the interest incurred on the borrowing will generally be non-deductible and will reduce the benefit of accessing the lower inclusion rate.

Even if you have necessary cash on hand, there is an opportunity cost to using that cash to pay the taxes instead of using it for some other purpose such as investing. 

Present value

If you crystallize an accrued gain, you have to pay tax now. If you don’t crystallize, then you don’t have to pay tax until the underlying asset is eventually sold. However, the increase in the inclusion rate means that the tax payable in the future will be a larger amount.

Despite the larger tax liability when the asset is eventually sold, it may be the case that the present value of that tax liability is less than the tax liability that would arise on crystallization. This is especially true in a high interest rate environment, such as the one we are in now. Therefore, it’s important to compare the present value of the cashflows under both scenarios when deciding whether to crystallize or not. 

When performing such an analysis, it’s important to remember that the calculation should only be based on the accrued gain at June 24, 2024. Gains accruing after that date will generally be subject to the 66.67% inclusion rate[2], whether the accrued gain to June 24 is crystallized or not.

Personal capital gains

Alternative Minimum Tax

Individual taxpayers who are planning to crystallize an accrued capital gain should consider the impact of alternative minimum tax (AMT) on their planning. Read our summary of the new AMT rules to understand how they might impact your situation.

If you’re a taxpayer who realizes large capital gains in a particular taxation year, you’re likely to incur AMT. If you’re unable to recover that AMT in the next seven taxation years, then the AMT incurred becomes an absolute cost of crystallizing a capital gain. Even if you recover all of the AMT paid, the related cashflows impact your present value analysis.

Assets with modest accrued gains

If the asset with the accrued gain is held personally, then it’s important to remember that the first $250,000 of capital gains realized by an individual in a tax year will still be eligible for the 50% inclusion rate[3]. Thus, crystallizing a capital gain on an asset with a modest accrued gain will accelerate the payment of tax on the accrued gain, but generally won’t change the amount of tax payable on that gain.

The amount of tax payable will depend on your marginal tax rate in the year the gain is realized. If you’re in a low tax bracket for the current year but expect to be in a higher tax bracket in future years, then it may be beneficial to crystallize even modest accrued gains. Doing so will accelerate the payment of tax on the accrued gain but should decrease the amount of tax payable on that gain.

If you have multiple assets with modest accrued gains and those gains are all realized in the same tax year[4], your total capital gain for that year might exceed the $250,000 limit for the 50% inclusion rate.  Crystallization may be beneficial if it prevents some of your accrued gains being taxed at the 66.67% inclusion rate.

Assets with large accrued gains

For assets with large accrued gains, you should compare the present value of the estimated tax payable on the accrued gain when the asset is eventually sold against the tax liability that will arise on crystallization.

Crystallization methods

To crystallize the accrued gain on an asset, you need to implement a taxable transfer of the asset at fair market value while still retaining control over it. This could be accomplished by transferring the asset to a holding company, a personal trust, or a spouse/common-law partner.

1. Transfer to a holding company

Transfers of assets to a corporation generally occur at fair market value for income tax purposes unless you and the corporation file an election for the transfer to occur at some lesser amount.

Before undertaking such a transfer, you should consider the impact of the corporate attribution rules. Under these rules, you might be required to include a benefit in your income, based on the value of the transferred asset and the prescribed rate of interest from time to time.

Caution should be exercised if the asset with the accrued gain is expected to accrue additional gains after being transferred to a corporation. Gains accruing after the transfer date will eventually be taxed in the corporation. The combined corporate and personal tax payable on such gains[5] will be greater than the tax that would have been payable by you on these gains if you had realized them personally. This is because the integration[6] of capital gains realized in a corporation is poor, especially so in the case of a Canadian-controlled private corporation.

A final consideration is whether you should crystallize accrued gains on assets being transferred to a corporation. If you increase your ability to access the Lifetime Capital Gains Exemption or the proposed Canadian Entrepreneurs’ Incentive on a future sale of the corporation’s shares, then crystallizing an accrued gain on such a transfer could cause you to incur personal tax that you wouldn’t otherwise have incurred.

2. Transfer to a trust

Transfers of assets to a trust generally occur at fair market value for income tax purposes. In certain cases, the transfer will be deemed to occur at cost, but it might be possible to file an election for the transfer to occur at fair market value.

Before undertaking such a transfer, you should consider the impact of the income attribution rules on income from the asset after the transfer date and gains realized on the disposition of the asset after the transfer date. These rules could cause such income and gains to be taxed in the hands of someone other than the beneficiary that the trust allocated them to.

Caution should be exercised if the asset with the accrued gain is expected to accrue additional gains after being transferred to a trust because gains accruing after the transfer date will eventually be taxed in the trust[7] and the inclusion rate for trusts is 66.67%, even for capital gains less than $250,000. 

3. Transfer to a spouse/common-law partner

Transfers of assets between spouses automatically occur at cost for income tax purposes. Therefore, to crystallize an accrued gain, you and your spouse need to file an election for the transfer to occur at fair market value. 

Before undertaking such a transfer, you should consider the impact of the income attribution rules on income from the asset after the transfer date and gains realized on the disposition of the asset after the transfer date. These rules could cause any such income or gains to be attributed back to the transferring spouse. 

Other taxes

Before transferring assets to crystallize accrued gains, you should also consider whether any other taxes will be payable as a result of the transfer. For example, transfers of real estate could attract land transfer taxes.

Professional fees

If you wish to crystallize accrued gains, you will inevitably incur professional fees to do so. If the strategy involves the creation of a corporation or a trust, you will also incur professional fees for annual legal and tax compliance filings for the corporation or trust.

Trust capital gains

All capital gains realized by a trust will be subject to a 66.67% inclusion rate. Unlike individuals, trusts are not eligible to use a 50% inclusion rate on the first $250,000 of capital gains in a year.

So, for a trust holding assets with accrued capital gains, whether it’s beneficial to crystallize or not will generally come down to a comparison of the present value of the cashflows under each scenario.

However, it’s important to note that a trust might be able to distribute assets to its beneficiaries on a tax deferred basis. Where this is possible, the trust could distribute assets to its beneficiaries and the accrued gains on those assets could be realized by the beneficiaries of the trust. If the beneficiary is an individual, they might be able to access the 50% inclusion rate on the first $250,000 of capital gains in a taxation year.

Crystallization methods

To crystallize the accrued gain on an asset, the trust needs to implement a taxable transfer of the asset at fair market value while ensuring that either the trust or a beneficiary retains control over it. This could be accomplished by transferring the asset to a holding company or to a beneficiary of the trust.

1. Transfer to a holding company

Transfers of assets to a corporation generally occur at fair market value for income tax purposes unless the trust and the corporation file an election for the transfer to occur at some lesser amount.

Before undertaking such a transfer, the trust should consider the impact of the corporate attribution rules.  Under these rules, the trust might be required to include a benefit in its income, based on the value of the transferred asset and the prescribed rate of interest from time to time.

As discussed above under ‘Personal capital gains’, caution should be exercised if the asset with the accrued gain is expected to accrue additional gains after being transferred to a corporation.

2. Transfer to a beneficiary

Transfers of trust assets to a Canadian resident beneficiary[8] generally occur at cost for income tax purposes. Therefore, to crystallize an accrued gain, the trust and the beneficiary need to file an election for the transfer to occur at fair market value.

Transfers of trust assets to a non-resident beneficiary[9] generally occur at fair market value for income tax purposes. 

Other taxes and professional fees

As discussed above under ‘Personal capital gains’, the trust should consider whether crystallization will result in other taxes payable, and the professional fees that will be incurred to implement a crystallization plan.

Other issues for trusts and their beneficiaries

While trusts are subject to income tax on their income, it’s very common for a trust to “allocate” its income to the beneficiaries of the trust. When this is done, the trust’s income is taxed in the beneficiary’s hands instead of in the trust’s hands.

At this time, it’s unclear how the allocation of a trust’s capital gains to its beneficiaries will work under the proposed changes. For example, if a trust crystallizes a $500,000 capital gain before June 25, 2024 and allocates the entire gain to a beneficiary when it files its December 31, 2024 T3 Trust Income Tax and Information Return, what inclusion rate will apply to the beneficiary? Will the beneficiary have a 50% inclusion rate on the entire capital gain because the trust realized the gain before June 25? Or will the beneficiary’s inclusion rate be 50% on the first $250,000 of the gain and 66.67% on the balance of the gain.

This uncertainty makes crystallization planning for a trust all the more difficult.

Corporate capital gains

All capital gains realized by a corporation will be subject to a 66.67% inclusion rate. Unlike individuals, corporations are not eligible to use a 50% inclusion rate on the first $250,000 of capital gains in a year.

So, for a corporation holding assets with accrued capital gains, whether it’s beneficial to crystallize or not will generally come down to a comparison of the present value of the cashflows under each scenario.

Unlike a trust, a corporation is generally not able to distribute assets to a shareholder on a tax deferred basis. Any such distribution would be considered a disposition at fair market value and would cause the corporation to realize the accrued gain.

Crystallization methods

To crystallize the accrued gain on an asset, the corporation needs to implement a taxable transfer of the asset in a manner that allows the shareholder to retain control over it. This could be accomplished by transferring the asset to a shareholder that is an individual, to another corporation, or to a partnership.

1. Transfer to a shareholder that is an individual

Transfers of assets to a shareholder generally occur at fair market value for income tax purposes.

Transferring the asset to a shareholder that is an individual could be advantageous because gains accruing after the transfer date would be taxed in the individual’s hands. This could be beneficial for two reasons:

  1. The individual may be able to have a portion of such gains subject to the 50% inclusion rate for individuals on the first $250,000 of capital gains realized in a taxation year; and,
  2. Having gains accruing after the transfer date taxed in the individual’s hand instead of inside the corporation could avoid the integration penalty[10] that comes with realizing capital gains inside a corporation.

2. Transfer to another corporation

Transfers of assets to a corporation generally occur at fair market value for income tax purposes unless the transferor and the other corporation file an election for the transfer to occur at some lesser amount. The assets could be transferred to a parent company by way of a dividend in-kind, or to a sister company or subsidiary for consideration of cash, or shares or debt of the transferee.

Provided that the transferee is the same type of corporation as the transferor[11], then the tax payable on gains accruing after the transfer date should not change.

3. Transfer to a partnership

Transfers of assets to a partnership generally occur at fair market value for income tax purposes unless the transferor and the partnership file an election for the transfer to occur at some lesser amount.

Few taxpayers already have a partnership in their structure, so this option would require setting one up. The partnership will most likely be a limited partnership, so the taxpayer will need another corporation to serve as the general partner. Limited partnerships are created under provincial partnership law, and need to be registered with the province, just like a corporation.

Other taxes and professional fees

As discussed above under ‘Personal capital gains, the corporation should consider whether crystallization will result in other taxes payable, and the professional fees that will be incurred because of crystallization.

Other considerations for Canadian-controlled private corporations

If the corporation holding an asset with an accrued gain is a Canadian-controlled private corporation (CCPC) whose shares qualify for the lifetime capital exemption, it may be counter-productive to crystallize the CCPC’s accrued gain. If the taxpayer can sell the shares of the CCPC and shelter the capital gain on sale with the lifetime capital gains exemption, then there’s no benefit to crystallizing accrued gains on assets owned by the CCPC. The CCPC has incurred corporate tax that it didn’t need to.

If you made it to the end of this article, you’ll no doubt understand now that the decision of whether to crystallize accrued capital gains or not is a complicated one. There are several considerations that have nothing to do with the change in the inclusion rate, and the analysis may require predicting your future capital gains and your future marginal tax brackets.

It’s also important to note the possibility that, if the next Federal election results in a change in government, the new ruling party could repeal the change to the inclusion rate. If this occurs, then taxpayers will have prepaid tax on their accrued gains but won’t realize any benefits from doing so.

As mentioned, please contact your DMCL advisor to discuss whether crystallization is right for you.


Article written by Stewart Bullard, CPA, CA

[1] I.e., a sale of the asset where the seller does not retain any direct or indirect ownership in the asset.

[2] Subject to individuals having the ability to use a 50% inclusion rate on the first $250,000 of capital gains in a taxation year.

[3] For the 2024 tax year, the $250,000 limit applies to capital gains realized after June 24, 2024. For subsequent tax years, it applies to capital gains realized at any time in the year.

[4] E.g., as a result of a deemed disposition of the taxpayer’s assets at fair market value upon the death of the taxpayer.

[5] The corporation will incur tax when it realizes the accrued gain, and the taxpayer will incur personal tax when the corporation distributes the after-tax sale proceeds to the taxpayer as a dividend.

[6] Integration is a guiding principle in Canadian taxation which says that whether income is earned personally or earned thru a corporation and distributed to its shareholder as a dividend, the total tax payable under either scenario should be the same.

[7] Unless the trust allocates the gain to a beneficiary.

[8] I.e., a beneficiary that is resident in Canada for income tax purposes

[9] I.e., a beneficiary that is not resident in Canada for income tax purposes

[10] See ‘Transfer to a holding company’ under the ‘Personal capital gains’ section above.

[11] E.g., a Canadian-controlled private corporation, a private corporation, or a public corporation.