Andrew Pyle
April 19, 2024
Portfolio considerations in the face of higher capital gains taxes
This week, the federal government unveiled a budget that neither addressed Canada’s fiscal excess, nor the anemic productivity situation. While the budget deficit, as a share of GDP, is not as bad as the U.S., our economy is also not as robust, nor does the trajectory look promising. The decision to increase the capital gains inclusion rate from 50% of gains to two-thirds was hardly surprising and it has been anticipated for the past few years. I will pause to note here, that for individuals the increase applies to annual capital gains over $250,000, but for corporations and trusts it applies on the first $1. Since the measure was accompanied by increased spending, it is going to do very little to bring the budget deficit down sooner than expected. It will, however, have potentially negative implications for capital investment and equity market performance.
Before we dig into this tax change, allow me to go on a little journey back in time. Back in the early 1990s, prior to becoming an advisor, I worked as economist/analyst for a company that many of you will not have heard of before – MMS International. Founded by a renowned Federal Reserve watcher, Bob Jones, the company was the world’s first source of real-time market analysis for fixed income and foreign exchange trading desks around the globe. When something happened, whether it be an economic data release, a budget, election result or some other major geopolitical event, we would provide opinions and recommendations on how it would impact markets. These opinions were unbiased and, when it came to reviewing policy decisions, sometimes critically so.
Back in the day, if you were an economist for a Canadian financial institution there were limits to just how critical you could be, which is why MMS did so well. Trading desks didn’t want sugar-coated analysis. For that reason, the federal government and Bank of Canada were very interested in what we had to say regarding policy initiatives. One day, I was invited to a breakfast meeting with then Finance Minister Paul Martin. The purpose was to go over the details of his 1994 budget, which coincided with a federal deficit that year of $42 billion. His intent was to balance the budget in five years and made clear during the meeting that he was fully committed to achieving that target.
By 1997-98 the budget balance was in surplus, paving the way for tax cuts in 2000. This included personal and corporate income taxes, but also a decrease in the capital gains inclusion rate from 75% to 67% and then ultimately to 50%. It remained there until this week’s budget and on June 25th, we head back to 66.7%. Our tax and estate planning specialist, Jamie Golombek, put out a thorough analysis of the main items in the budget, which you can read here.
The budget talks about how this change is only going to impact a sliver of the population, which are in the top income bracket, and about 12% of corporations. It is important to note that when the budget breaks out income thresholds, it includes income from capital gains. If stripped out, the percentage of households in the highest bracket declines. The more pertinent consideration is that a lot of the unrealized capital gains that exist in personal and corporate portfolios have built up over many years. I have known many investors who owned bank stocks with an adjusted cost per share equal to the annual dividend per share today. In other words, their unrealized gains were massive. I will return to how and why these gains accumulated later.
By choosing to implement the higher capital gains inclusion rate on June 25th, the government may cause some to take profits on legacy stock holdings beforehand in order to pay less tax. All things being equal, this could put more downward pressure on the Canadian market relative to others. This will obviously depend on individual circumstances and what tax advice they receive, but it is difficult to see how many won’t be motivated to trigger gains now versus later.
Keep in mind that we aren’t just talking about non-registered investments. Individuals and private corporations that own secondary properties, like cottages, are going to be in the same situation. The decision to liquidate property is much different than selling liquid investments. As such, we are probably not going to see a flurry of sales in the coming weeks, however, there are situations where it might be prudent to act now. Let’s say that, as part of your estate plan, you have considered gifting your cottage to your children, in order to reduce probate. Whenever that was going to take place, it would represent a deemed disposition and you would have paid tax on 50% of the realized gain. If that plan was going to be executed, say later this year or even next, then your tax professional might suggest doing so before the inclusion rate moves higher.
Getting back to my earlier comment on why some Canadians have large legacy gains in their portfolio, we must recognize that this isn’t just because we are a nation of buy-and-hold investors. One of the reasons people are sitting on large gains is because they didn’t want to trigger tax on that gain. In effect, capital gains tax ends up reducing the flow of capital and sometimes puts individuals in a position where they hold investments that may no longer be appropriate for them. Now that the government has raised the inclusion rate, the disincentive to sell a security or trim it back is now even larger.
In those situations where investors do take advantage of the window before June 25th and trim back securities with large gains, this doesn’t mean that all those stocks have been doing well recently. For example, Canadian telecommunication shares have had a challenging year, yet may represent sizable legacy gains in some portfolios. If there is a higher incidence of selling in order to lock in the 50% inclusion rate, this could put these stocks on an even worse trajectory. On the flip side, any selling pressure that emerges before June 25th could open up some interesting opportunities in the Canadian market for domestic and foreign investors.
Bottom line, the decision to raise the capital gains inclusion rate is going to create potential distortions in Canadian markets and further reduce the efficient flow of capital, not to mention reinforce improper asset allocations. The arbitrary choice of implementation date could also create an accounting headache for some. From the perspective of the economy, the much-needed improvement in productivity relative to the U.S. is now even less likely and that could have a longer-term impact on equity market in comparison.
On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.
Andrew Pyle
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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. Andrew and his clients may own securities mentioned in this column. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.
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