Realizing capital gains for CCPCs before June 25

Budget 2024’s proposed increase in the capital gains inclusion rate to two-thirds from one-half, effective June 25, has left many incorporated business owners and professionals wondering what to do with unrealized capital gains in their corporations.

This decision is much more involved for assets held in a corporation than it is for assets held personally. On a personally held asset, the potential tax savings of realizing a gain at the current (pre-June 25) inclusion rate is simply traded off against the loss of tax deferral by realizing the gain earlier than planned. The result boils down to a break-even number of years: if a gain can be delayed for that number of years, deferring is advantageous.

A corporation, on the other hand, acts like a dam that moderates the taxable income flowing to its shareholders. This deferral mechanism creates unique planning opportunities and makes the decision between realizing and deferring a capital gain more complex. While there is still a loss of tax deferral at the corporate level, realizing a gain in a Canadian-controlled private corporation (CCPC) may create an opportunity to defer personal taxes.

Capital gains in a CCPC

A capital gain realized in a CCPC results in corporate taxes on the capital gain, and a credit to the capital dividend account (CDA) — a notional account that can be distributed tax-free to a shareholder of the corporation. Notional accounts like the CDA are intended to achieve tax integration — a state in which investors are indifferent to realizing a capital gain personally or in their corporations.

The Budget 2024 proposals affect integration by applying the increased inclusion rate to all capital gains realized in a corporation, while providing a $250,000 threshold to earn capital gains personally at the current lower inclusion rate.

When a capital gain is realized in a CCPC, the taxable portion — currently 50%, and a proposed 66.67% after June 25 — is taxed as passive income at a tax rate close to the highest personal marginal rate. A portion of that tax is refundable when the corporation pays out a non-eligible dividend to a shareholder, who would then pay personal tax on the dividend.

The non-taxable portion of the gain is credited to the CDA. When there is a positive CDA balance, a special election can be filed to pay a tax-free capital dividend to the corporation’s shareholders. While tax-free, the gain should be large enough to justify the accounting fees required to file the special election.

Let’s look at the example of a $1,000 capital gain earned in a CCPC in Ontario before and after June 25.

Before June 25, half of the gain is taxable. There are non-refundable taxes of $97.50 and refundable taxes of $153, for a combined total of $251. The non-taxable half is credited to the CDA. When flowed through to the personal level at the highest personal rate, there is $710 remaining, for a total tax rate of 29% on the capital gain.

After June 25, two-thirds of the gain is taxable. Non-refundable taxes increase to $130 and refundable taxes to $204, while the CDA is reduced to $333. In this case, when flowed through to the personal level, there is $614 remaining, for a total tax rate of nearly 39%.

CDA and tax deferral

Looking at a corporation in isolation, there is a simple break-even calculation for whether it makes sense to realize or defer capital gains leading up to June 25, just as there is for a personally held asset. But corporations do not exist in isolation. The math changes when the dollars needed to fund the personal compensation of a shareholder are considered.

Remember from the previous example that realizing a $1,000 capital gain before June 25 in a CCPC would result in about $710 in personal after-tax dollars. To achieve the same after-tax result with non-eligible dividends at the top Ontario marginal rate would require $1,359 to be paid out, due to personal taxes being much higher; salary would require $1,529 to be paid out.

Harvesting a capital gain results in a loss of tax deferral on the capital gain in a corporation but creates a separate source of tax deferral. It reduces personal taxes payable on a given amount of after-tax spending needs. This strategy is far more effective before June 25 than after, due to higher corporate taxes and a lower credit to the CDA.

Even before June 25, this planning will not always be favourable. For example, if your personal tax rate on non-eligible or eligible dividends is below the roughly 10% paid in non-refundable corporate taxes on a capital gain, deferring the gain will look more attractive all else equal. Similarly, if the refundable portion of the taxes on the capital gain will be trapped in the corporation indefinitely due to low personal spending needs, deferring will look relatively attractive.

Other considerations

A large capital gain in a single year may shrink the CCPC’s small business deduction (SBD) threshold in the following year, increasing corporate taxes payable on net active income.

If you need to pay out more dividends in the future to access refundable taxes incurred on a large capital gain, that may come at the expense of not paying as much salary. Paying a salary comes with many other benefits, like RRSP/individual pension plan room and CPP contributions.

We have used personal spending as an example of a reason to take money out of a CCPC, but using a capital dividend is also a tax-efficient way to fund a TFSA or make personal debt repayments. Similarly, if there is a lower-income shareholder spouse, it may be possible to allocate capital dividends to them. This could allow them to invest the proceeds in their personal taxable account directly, or free up their other sources of income for saving.

How to advise clients

The capital gains inclusion rate proposals present an incredible opportunity for thoughtful planning around the use of unrealized capital gains in a CCPC.

Since we started talking about optimal compensation strategies for CCPCs on the Money Scope podcast, it has become increasingly clear that this topic is generally poorly understood and offers an enormous opportunity for practitioners to add value.

This topic spans both financial and tax planning across multiple years. Advising on it must be done in the context of an overall financial plan. In many cases, realizing — or harvesting — capital gains on assets in CCPCs before June 25 and using tax-efficient capital dividends to reduce personal taxes owing in future years may be a favourable trade-off.

We have been busy modelling how these pieces interact and fit together and will illustrate some cases in a followup article.