Understanding the implications of the 2024 Federal Budget and its proposed changes to capital gains taxation is crucial for individuals and corporations alike. In today’s episode, we take a deep dive into the Canadian federal budget for 2024 and its impact on capital gains taxation. In our conversation, we discuss the technical details of capital gains taxation and its historical context and offer practical advice for navigating the proposed changes in the 2024 federal budget. We discuss the increase in the capital gains inclusion rate and how these changes will affect individual investors and corporations. Discover the mechanics of capital gains tax in Canada, essential tax planning strategies, the importance of diversified tax exposure, and the concept of capital gains harvesting. Gain insights into the impact of the changes on the retirement plans of incorporated business owners and professionals, the role of optimal compensation in realizing capital gains, and approaches for navigating the proposed changes. Join us as we delve into the complexity of tax planning for incorporated business owners and the importance of long-term projections, personalized advice, and strategic decision-making for realizing a capital gain. Tune in now!
[0:00:02] BF: Welcome to the Money Scope Podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, portfolio manager and head of research at PWL Capital, and Dr. Mark Soth, AKA the Loonie Doctor.
[0:00:17] BF: Welcome to episode 15 of the Money Scope Podcast.
[0:00:20] MS: Great. This week, we’ve called in the Money Scope endoscopy team for an urgent procedure. We’ve got the Canadian Federal Budget that dropped recently for 2024. This is a topic that’s going to be a break from our regular curriculum, but it’s time-sensitive and very relevant to our audience with the changes that are proposed for capital gains taxation. Also, beyond that immediate issue, which is proposed to take effect on June 25th, this is also an opportunity, actually, to highlight some important planning concepts that are going to apply regardless of the budget changes.
[0:00:52] BF: That’s right. That’s one of the reasons that this is such an interesting topic. The budget proposes to increase the inclusion rate on capital gains. We’ll get into the details of what that means in the episode, but the current proposals would affect people who use their corporation to invest more than it would affect individual taxable investors. Again, we’re going to get into the details about why that is. Like you said, Mark, that’s what makes it relevant to our audience.
Now, I don’t know about you, Mark. I actually do know about you. We’ve been talking about it a lot, but modelling these proposals, we were talking about before we started recording just now, their expected impact and what to do about it and all that stuff with people who have unrealized capital gains right now, it has become an obsession for me since literally the minute that I read the budget proposal.
[0:01:34] MS: Same here. I have these little Excel grids that are burnt onto my retinas. It’s like, I need to get some of those solar clip glasses or something. I just been spending so much time looking at this and it is, it’s totally addictive. It’s been great though, because we’ve built models separately using different approaches. We approach things differently, but we’ve been doing it in in parallel with each other, which has been reassuring because this is a very complex mix of tax and financial planning factors all put together.
It’s also not intuitive and the results of different strategies, they unfold over a number of years. It’s been great because we’ve been sharing what we’ve been doing along the way to make sure that our numbers relatively match up to each other, even though we have different methodological approaches, but the results are actually lining up pretty closely, which is great.
[0:02:19] BF: Yeah, they are. When they don’t line up, I panic.
[0:02:21] MS: Well, me too. It’s like, I’ll get the email and my heart will start palpitating.
[0:02:25] BF: Oh, man.
[0:02:26] MS: I have to deal with it before I go to bed, or I’ll be dreaming about it.
[0:02:30] BF: No, I’m telling you, this is becoming an obsession. We’ve also tested a lot of different scenarios and when we’ve found lots of interesting little nuances and we’re going to unpack some of that today. One thing this highlights, I think, on this general concept is that the best strategy for any individual is going to be very specific to their situation. The optimal strategy, it depends on your province. It depends on your income. It depends on your outside sources of income. It depends on your consumption needs, so how much you need to pay yourself from your corporation. It depends on investing and how the corporation is invested and a lot of other factors.
There’s so much variation in outcomes that are so sensitive to small changes in the assumptions. More so, I would say than in a lot of other financial planning modelling that I’ve done in the past, to come up with a rule of thumb for anything around the stuff we’ve been modelling is relatively difficult. We’re going to try and give some colour and some intuition in this episode, but this is no joke. This is not just a standard disclaimer to consult your advisor. We really mean it this time.
Now, we always mean it, but we really mean it this time. With that said though, this is an area where we’ve both shown this with our modelling, where smart planning can make a difference in how much after-tax money you’ll have at the end of the day. There’s also a big component of mitigating your vulnerability to the type of legislative risk that this budget brought to light, which is tax risk in this case. Using accounts other than a corporation as part of a diversified investing plan is something that we’ve talked about, and this change, I think, really highlights why that’s so important.
[0:03:57] MS: We talked about that in previous episodes, I think just right on time, just for the budget drop.
[0:04:01] BF: Yeah. Yeah, we did.
[0:04:02] MS: Disconfirmed for geniuses. Got to take the lucky wins. But yeah, using registered accounts, managing debts, sometimes even helping a low-income spouse to invest, those are all ways that of investing that have different tax characteristics, and they help to diversify you against these types of tax changes, like when the budget dropped. Other than the insatiable need to try to model it, I wasn’t too worried about it, because we’ve actually dealt with a lot of this over time with our own finances.
In this episode, we’ll describe some of the strategies that you may want to discuss with your advisors. For example, I’ve been talking about what I call capital gains harvesting, and using the capital dividend account in a corporation for several years now. I know that there’s people on the PWL team that have also been talking about, hover outside of that and very few people seem to think about it. It breaks with some rules of thumb. It’s counterintuitive on the surface, but when you actually work through it, it could make sense for some situations. For you to have those kinds of discussions, though, it’s going to require you to have some basic understanding about the capital dividend account and what you’re trying to do with this, if you want to discuss it with your advisors, just so that it doesn’t get dismissed out of hand, there’s some real good thought and discussion that goes into the answer for you.
[0:05:17] BF: Totally. Capital gains harvesting is a specific strategy that we will talk about, but we’re going to start right at the beginning and go through this topic in detail as we’ve done in past episodes. We’re going to talk through how capital gains taxes work in Canada, how the budget proposals will affect the tax rate if they are passing a law on capital gains for both individuals and corporations. We’ll talk with the expected impact on the retirement plans of incorporated business owners and professionals, which is a topic that I think is really at the heart of all of the stuff that we’re talking about.
We’ll also talk about how optimal compensation, our topic from episode 13, fits into the decision to realize it for capital gains on a corporation. That piece, I mean, man, we were talking before we started recording about how important optimal compensation is. I think this modelling that we’re going to talk about in this episode really highlights why it’s so important.
[0:06:05] MS: It’s funny, because it underpins, basically, all of financial planning with the corporation, and I don’t think it’s appreciated, or used by a lot of people. Then anytime you think about any corporate strategy, it’s like, if you were to have a study of some heart drug and you didn’t use the standard of care heart drug in your control group, well, whatever your study, is not that meaningful. You really have to have, using your corporation optimally as the baseline. Then what do you do differently on top of that? That’s how we’ve approached this project is that we’re assuming that your corporation is being used efficiently, and is there a difference if you do one thing or another, or how do you plan for these changes?
In doing so, this episode really draws on many of the concepts that we’ve covered in those past episodes, so there is going to be some repetition, but again, these are complex topics that people don’t talk about. That’s probably a good thing. This is an opportunity to talk about that again from a different angle and actually using in a practical situation where we had this somewhat unexpected tax change that could affect the outcomes.
[0:07:09] BF: I do want to mention that we, as listeners know, if they’re listening to this episode, there’s been a few weeks of a gap between our last episode and this one. Money Scope is still alive. We’ve both been hard at work on the budget, but we will be back with more curriculum-based episodes as we complete them. Each one is, as we’ve mentioned in past episodes, there’s a lot of work. We put a lot of thought and time into them, but we do have a few really big, juicy topics to finish off the series, so those will come out at some point.
[0:07:39] MS: Oh, yeah. They’re going to be even more juicy after the budget changes, too.
[0:07:42] BF: That’s true.
[0:07:44] MS: My inbox is filled up with all sorts of people selling different products. Anyways, we’ve dragged out the intro long enough that we can add the after-hours premium to our billing codes, so let’s get started with the topic.
[0:07:59] BF: Let’s kick it off with how capital gains tax works in Canada. A capital gain arises when you sell an asset for more than its adjusted cost base, which is what you paid for the asset, plus any expenses related to acquiring it. For example, if you buy a stock for $10,000 and then later sell it for $15,000, the difference, the $5,000, is a capital gain. Other little details, like your transaction costs would factor into that calculation, too. Capital gains in Canada are not fully taxable. That piece is important, because that is the mechanism that the budget is using to affect how capital gains will be taxed. The amount of the gain that’s taxable is based on the capital gains inclusion rate. Currently, as of today and until June 25th, that rate is 50%. So 50% of the capital gain is included in your taxable income.
The budget proposal would have that increase after June 25th to a two-thirds inclusion rate. The proportion of the capital gain that gets included in your taxable income is proposed to go up in certain cases. We’ll talk about the cases where that won’t happen in a bit. When you think about how this affects your overall taxes, the taxable portion of the capital gain is just added to your taxable income. The taxable portion is like income in terms of the way that it contributes to your taxes. Including the inclusion rate from a half up to two-thirds, effectively increases the tax rate on capital gains by about 33% in relative terms. It’s a big jump, but at the same time, capital gains are still taxed at a lower rate overall compared to regular income.
Just to put some numbers to it, the 2024 budget proposal would result in the top capital gains tax rate for individuals in Ontario, specifically. Would be different for other provinces. In Ontario, the top capital gains rate for individuals would increase to 35.69% from the current, as the time of recording, 26.77%. Then regular income is at 53.53%. You can see, the capital gains rate is still lower than income because only two-thirds inclusion, but it is proposed to go up a fair amount.
[0:10:05] MS: That sounds like favourable tax treatment, and it is. There’s actually a couple of factors that make capital gains a bit different from earn income that underlie the reasons why that treatment is a bit different. One is that you cannot spend money that’s represented by a capital gain until you actually sell the asset, so you can’t go and spend your stocks. You have to sell them, get the money, and then you can spend the money. That unrealized capital gain, it isn’t taxed.
Now in contrast, you can spend income as soon as you get it, so income’s taxed at that time. Now when you do sell the asset and get access to the money, that’s called realizing the capital gain. At that time, you have access to the money and it’s taxed. The other factor, which is more subjective, is that capital gains come from risking capital. One connotation to that is that you have to have capital to be able to risk it. That usually means that someone has earned income, paid tax on that, and instead of spending the money that’s left, they’ve decided to invest and risk it. Could be in the case of stock options, employees may have done work, but they’ve forgone taking cash income and risk the value of their labour in the hopes that their contributions will grow the value of the business instead. If that works out, then great. But it is a risk. It’s not a guarantee, like you show up to work and you get your income. Now, if you’re faced with extra after-tax money, most people will be sorely tempted to spend it on something fun, rather than take it and investing.
[0:11:35] BF: Like a nice trip, or a new bike.
[0:11:37] MS: Or beer and hot tubs. Anyway, for our economy to innovate and grow, it does require that some of that money be redirected from beer and hot tubs to risking capital through investing in businesses. Either directly, like in your own business, or through equity type of investments. Because there’s that decision that needs to be made and it’s a tough one, it does require some incentive for people to risk their capital. That’s why capital gains are partially taxed is to help provide that incentive. Capital losses can also be used to offset gains, so the government actually also shares in some of that risk. That’s why it’s given a bit of a favourable tax treatment.
Now, those without enough guaranteed retirement income have an added incentive to risk capital, because they have to. They have to be able to grow their capital to provide for their own retirement. Those who spend everything that they make, whether on basic needs or in adding in some luxuries, don’t really have the capital to invest. It is more likely that those with higher incomes, or more frugal lifestyles will have capital to invest and hopefully, not a guarantee, but hopefully, earn capital gains. That’s some of the underlying mechanisms at work there, even though you may hear parts of the story here and there, depending on the spin that’s put on it.
This is the issue. I mean, how much incentive is required to invest via the free market and grow our economy, versus how much should be taxed and then provide services that are directed by the government? Instead, that’s subjective. You can use extreme cases at either end of the spectrum to try to support moving taxes on capital gains in one direction, and higher or lower. Reasonable people, they can disagree on the middle ground is subjective. That, and the fact that it’s not as intuitive for most people as earned income, people understand earned income. Capital gains is a little bit more nebulous. I mean, you put those factors together, it makes it an easy political target, which is what we’ve seen.
[0:13:34] BF: Is there an inflation reason there, too, assets increase with inflation? So, not tasking the full amount?
[0:13:39] MS: There is. If you own something for 30 years and it goes up in value, how much of that value is an increase in economic buying power, versus how much of that value is just inflation. Then if you’re taxing the full amount, well, you’re basically taxing inflation. The other argument against that would be, well, marginal tax rates are supposed to increase with inflation. That may undo some of that effect. I don’t think that’s a perfect relationship. I think that’s probably baked in there somewhat, but it’s not going to be perfect. I mean, a lot of that depends on how much is inflation running at to.
[0:14:12] BF: That’s a good point. I’m not super strong on the theory of capital gains tax. There’s a whole book that I hadn’t read, but I identified the book that you would read if you wanted to learn about the theory behind capital gains and why they’ve been the way they have been throughout history and how they are now and all that kind of stuff. It’s complicated and there’s so much rhetoric on both sides saying like, why one thing is right and the other one’s not.
We do have a professor at UBC who’s an expert on among other things, capital gains taxation in Canada specifically, who has agreed to come on rational reminder later this year. I haven’t pinned him down for a date yet, but I’m hoping that we’ll be able to cover that, because I think it’s a really interesting topic. Anyway, without going too down the political rabbit hole, I do think it’s important to note that historically, the inclusion rate has gone up and down. I don’t know about the theory behind capital gains, but I can tell you empirically what rates have looked like over time.
Just like with marginal tax rates, it’s changed by different political parties over time depending on what’s happening with the country’s finances and market forces and what the nature of that political party that’s in power is at the time. If you look at Canada’s history, before 1972, capital gains were not taxed at all, which is interesting. Then since 1972, the top combined federal and provincial capital gains tax rate for individuals in Ontario, and I’m using Ontario again just because I was able to get historical data for Ontario specifically, I was not able to get it for other provinces, at least not easily. It’s been as high as 39% in the 1990s, as low as 23% in the 2000s, so it’s varied quite a bit.
Just to reiterate, the 2024 budget proposal would set the top capital gains tax rate for individuals in Ontario at a little more than 35%. That’s a function of the marginal tax rate multiplied by the inclusion rate on capital gains. This would put it not at the highest that it’s ever been, but pretty close. Not too far off. Now most of that variation in capital gains tax rates over time has been due to changes in the capital gains inclusion rate, more so than changes in the marginal tax rate. It’s been 50% since the year 2000, up until recently, potentially. We keep saying potentially, because these are still proposals. They have not been passed in a law. That’s an important thing for people to note. This is all just an idea that could happen, although Deputy Prime Minister Freeland has been pretty clear that they plan on getting draft legislation in place. Anyway, that’s why we keep alluding to this as a proposal, or not quite a real thing yet.
Inclusion rate was 75% from 1990 through 1999. It was 66% in 1988 and 89, which I think were transition years, and then it was 50% before that. I think the most common rate if you look through past years has been 50% and then there have been a few instances where it was higher. Then again, to reiterate, the overall tax rate on a capital gain is the inclusion rate multiplied by the income tax rate that you’re in.
The point here is that these changes occur over time. They occur by different political parties and power at the time. Historically, there have been big gaps between changes. You get a long period where the rate is persistent and then there’s a change for whatever reason. It’s not a surprise that capital gains taxes change. This is a thing that we know. We said earlier, Mark, we said that this could happen and it’s one of the reasons that you should diversify your tax exposures as much as you can. We also can’t say when it’s going to happen. Could be many more years before it changes again, or there could be an election and maybe it goes back down, or maybe it goes up further. Who knows? There’s just no way to say.
Again, it highlights that tax rate risk that I think is really important for people to think about and try and diversify away as much as possible. The example we always give is that instead of retaining everything in your corporation, you want to find ways to get money into your registered accounts, your personal registered accounts, your personal taxable accounts maybe, or a spouse’s taxable account. Again, this current budget proposal really highlights how even a taxable individual and the taxable corporation are very different investors from the perspective of how they can be treated from a tax perspective.
[0:18:18] MS: The most important message from that segment is that if you’re hoping that you’re just going to wait till the next election and everything is going to be undone, again, that’s highly unlikely to happen. I mean, these changes happen because of the fiscal position of the country largely. When we get dug into a deep hole, it takes many, many, many years to dig ourselves back out and we need tax revenue to do that. That’s just the reality of the finances. I wouldn’t think we’re going to have major changes just because our government changes. I mean, the politics are only one piece of the equation. There’s numbers that are behind all of that.
I think the key area where the current proposal strays from some of that previous change that we’ve seen up and down is that it really does actually now propose to treat individuals directly investing, versus investing through a corporation differently. The first $250,000 of gains earned by an individual be taxed on the current inclusion rate of 50%. But corporations, on the other hand, which is where many small business owners and professionals do a chunk of their investing, they’re going to pay tax based on the higher inclusion rate on the very first dollar of capital gains. There’s no threshold there. There’s no allowance for things to be ground down over time.
It’s a big deal. A capital gain realized in a corporation in Ontario will ultimately leave a shareholder in that province tax at a total rate of 38.62% on a realized capital gain compared to 28.97% individually. Corporations don’t get access to that $250,000 inclusion rate. That’s a pretty meaningful difference in taxation of a corporation versus an individual now. It’s a 10% difference.
[0:20:01] BF: Tax integration is one of the pillars of our tax system. It’s intended to make it fair by making the taxes paid by an individual directly roughly the same as the corporate, plus personal tax when you flow it through to a shareholder. This is something we’ve talked a lot about, how the mechanics of integration works. Now, it’s not perfect. In general, again, as we’ve talked about in past episodes, the corporate tax, plus the personal tax when you flow it through tends to be a little higher than if you earn the income directly as an individual. That’s that whole salary versus corporate tax, plus dividends discussion, which one’s more efficient. As we’ve talked, about salary tends to look pretty attractive relative to dividends with the many exceptions that we’ve talked about.
A corporation does also get the opportunity for tax deferral. There are already mechanisms to discourage that and incentivize corporate owners to pay out excess profits and the rest of the personal tax along with that, like the upfront tax on investment income approximating the highest marginal rate, which you can get some of it back when you pay dividends. That’s the whole RDTOH situation. We’ve also got passive income limits that bump up corporate taxes when there’s over $50,000 of passive income per year. There are mechanisms in place that discourage this a little bit. Again, as we’ve talked about in past episodes, you can attenuate some of those negative impacts with some thoughtful planning. That still applies with this latest budget change.
[0:21:21] MS: Yeah. That’s an important point. One of the most common questions that I’ve been getting is whether this now it just makes incorporation useless, basically, because it’s going to be taxed more aggressively. It certainly does make other options that were already better, like a TFSA, or an RRSP look even better. However, there’s still this opportunity to smooth out your income and your consumption using a corporation. That’s particularly important for hiring professionals and business owners because we have a late start. We have a condensed number of years to earn and invest for retirement. There’s wild fluctuations in our income along the way. That can happen if there’s changes in the business environment, or in your personal life, where you’ve got parental leaves, or six leaves, or other things that happen. You don’t have benefits related to cover any of that. Corporations are quite useful to help smooth some of that out. That’s a layer of cost and complexity, but it gives you some extra levers to pull while you’re planning your finances overall.
[0:22:19] BF: The tax deferral benefits of a corporation are still there. They’re still present. They’re slightly decreased, especially at the estate level from the modelling that I’ve done, which, like you said earlier, Mark, I’m sure you’ve gotten lots of emails from people selling permanent insurance. That’ll make that episode when we cover it that much more interesting. Yeah, the benefits of corporate deferral have not gone away.
Okay, let’s talk about capital gains in a CCPC and how that works and how they flow through to a shareholder. To know how to pull the planning levers that we’ve been mentioning and use a corporation, it requires an understanding of how it all works, which is what this podcast, at least the second half of it has been largely about. Let’s focus on capital gains. As a refresher. When a capital gain is realized in a Canadian corporation, there are a few different things that happen. The taxable portion of the gain is taxable to the corporation. Let’s say, we have a $200,000 gross gain at a 50% inclusion rate. We have a $100,000 taxable gain, and there’s a non-refundable federal part one tax of 8% on that taxable gain. There’s a refundable federal part one tax of 30.67%.
We’ve got a non-refundable federal tax of 8% and a refundable federal tax of 30.67%. That’s again, refundable when you pay a dividend, non-eligible dividend out to a shareholder. Then we’ve got provincial tax, which in Ontario, in this case is 11.5% of the taxable gain. In total, you add all that up, we have 50.17% in taxes owing on the gain, 30.67% of that is refundable when a non-eligible dividend is paid to a shareholder. Those are percentages based on the taxable portion of the gain.
[0:24:01] MS: Yeah. I mean, just to be clear, 50% tax and the 31% refund to the corporation, when personal tax is paid, it applies to that $100,000. The 200,000 gross capital gain would effectively have a 25% tax and a little bit over 15% refundable as the RDTOH refund. You put that together, that’s a net of about 10% gross tax on the gross capital gain in the corporation. About $20,000 on that $200,000 capital gain. That’s what the current inclusion rate. Then it’s only the tax inside the corporation.
There’s also personal tax on the dividends that you have to use and pay out to get that RDTOH refund to the corporation. Overall, when you add the corporate tax, plus the personal tax on the dividends, there is more tax to get access to the money than directly personally investing. It adds up to a little bit more.
[0:24:58] BF: There’d be tax on the non-eligible dividends required to get the NRDTOH refund. About $80,000 of non-eligible dividends would be required for our $200,000 capital gain example. At top Ontario rates, that would be another $38,400 of personal tax on top of the corporate tax that has already been paid. Then the other thing that happens is that the corporation’s capital dividend account is credited with the non-taxable portion of the gain. The capital dividend account allows capital dividends, which are tax-free to the shareholder to be distributed from the corporation. When we put it all together, it roughly emulates what happens personally, roughly in terms of the overall tax rate that you pay. But that piece is going to change pretty materially.
If we look at an example of a $1,000 capital gain earned in a CCPC in Ontario before and after June 25th, you can really see the difference. Before June 25th, half of the gain is taxable. That’s the 50% inclusion rate. This is a $1,000 capital gain. 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 capital dividend account. Then when flowing through to the personal level at the highest personal rate in this example, there is $710 remaining. We’ve got a total tax rate of 29% on the capital gain. That’s at the 50% inclusion rate. The total flow-through tax on a capital gain in a corporation is about 29%, which is a little bit higher than if you had earned that capital gain personally.
Keeping in mind that in the corporation, you didn’t have to pay the personal half of that tax, or the personal portion of that tax immediately. You could have deferred that, which comes with all kinds of other implications, like leaving your notional accounts in the corporation. Anyway, after June 25th, with two-thirds inclusion, two-thirds of the gain is going to be taxable. The non-refundable taxes in this case are going to increase to $130 and refundable taxes are going to increase to $204. Then the CDA is going to be reduced to $333 in this case.
We’ve got higher taxes, less capital dividend account. Now when we flow that through to the personal level, there is $614 remaining, which is a total tax rate personal and corporate combined of nearly 39%. Big jump relative to the 50% inclusion rate. Again, slightly higher than the personal taxes that you’d pay if you’d earned that capital gain personally.
[0:27:23] MS: Yeah, if you compare the personal tax rate versus flowing it through a corporation, it’s going to vary a little bit by province. This basically translates to about a 10% absolute tax increase on capital gains in a corporation on the first dollar compared to an individual. For an individual, it is a little bit more straightforward using the $1,000 capital gain for Ontario example. We do that as an individual investing, rather than a corporation at the top rate. Half the gain, $500 out of that $1,000 is taxed at 53.53%. Then the other half is tax-free. You just have to divide the marginal rate by two. It’s about 27% tax personally, which is about 10% or 12% less.
It’s already lower than the older corporate rate by about 2%. Now with that jump, it’s actually a 12% lower rate on that first $250,000 of personal capital gains, which is pretty substantial. On the personal capital gains above that $250,000 threshold, the portion that’s above it, the effective rate is going to go up to this 35.6%. That’s still a bit less than the corporate total, but it’s getting a bit closer with the tax integration again.
I would say, something that’s important is that with that personal threshold, there is an opportunity to realize gains below that with some planning. If you have something that’s relatively liquid and you can sell an in fractional portions, like a stock portfolio, for example, you could do that pretty readily, but it can get pretty tricky with some other assets. For example, selling big chunky assets, like real estate outside of your principal residence, or business. Or if you die and you have significant personal assets that are considered to be disposed of at death, those are all cases where you could go over that $250,000 limit without much choice about it.
It was really large capital gains and low sources of other income may also run in a follow of some of the alternative minimum tax rules as well. All of those potential situations require some thought and planning to attenuate at the individual level.
[0:29:36] BF: I do want to mention alternative minimum tax, or AMT. There’s a perfect storm of AMT relevance right now, because AMT, well, maybe just talk a little bit about what it is. So, the Canadian tax system has two parallel calculations. People don’t tend to realize this. One is the regular taxation framework that people tend to know about. We’ve got the marginal tax rates, we’ve got the deductions and all that fun stuff. People generally understand, at least on some level, how that piece of the tax system works. The other one is this shadow tax that gets calculated alongside your regular tax and that’s the AMT. This is applied by the CRA to ensure that those on high incomes pay a minimum amount of tax, no matter what deductions or credits they have.
If the tax owing calculated under the AMT is higher than what you would owe under the regular tax system, you pay the AMT. That’s why it’s there. Now, the important point to take away on this is that at the 50% inclusion rate, because of the way AMT is calculated, large capital gains will often trigger AMT, and that’s particularly true for people with low sources of other income. If you’re a really, really high salary, you can realize some pretty significant capital gains before you hit AMT. If you have a low salary, or low sources of other regular income, capital gains could trigger AMT more easily. A big reason for that is another budget proposal affects AMT. One of the big things is capital gains being included at 100% for the 2024 AMT calculation.
The way AMT works is a bunch of adjustments to your income and then you apply the AMT rate to that adjusted income. I won’t go into details about how the calculation works, but it’s just a warning that if you have personal assets that you’re considering selling before June 25th, AMT is going to be a meaningful consideration in projecting how much tax you’ll owe on that sale, which then affects whether it actually makes sense to sell the asset or not.
An important point on AMT is that it can be recoverable because it can be carried forward for up to seven years and it can be used to offset future taxes as long as your regular taxes exceed your AMT. You can mop up that difference, but the regular tax is in excess of AMT by using your AMT carry forward. If we think about a taxpayer, like who’s going to be hit by AMT? Well, it’s people who have large capital gains and low other sources of income. Someone in that situation is less likely to have future income sources that make them have enough taxable income to recover their AMT.
The other point here is that at two-thirds inclusion, capital gains will no longer trigger AMT. That’s an interesting point that I realized from modelling it. Then I saw a few other people who did analysis of the budget that made the same comment. But it’s this time right now between now and June 25th, where the combination of budget proposals on capital gains, which are going to push people to sell and the budget proposals on AMT, which have changed a few pieces of it, including how much of capital gains are included in the calculation, AMT has always been there, but for this decision specifically on whether to realize, or defer capital gains personally, it’s I think more relevant now than ever for a lot of people.
[0:32:50] MS: It’s a clever confluence of factors together. Try to get a bunch of revenue quickly before June 25th is what I think probably underlies it.
[0:32:59] BF: It seems that way. Yup.
[0:33:00] MS: That’s just speculation. One of the other important changes with AMT is that the amount of income that’s excluded from the calculation has also been raised to. It’s been raised up to $173,000. It would take quite a large capital gain coupled with low levels of regular income to get caught up in it, even in this window that we’ve got. It could happen. For example, some with a low income and a valuable secondary property, like a cottage that they’ve had for a really long time or something that could trigger potentially, they may be able to recoup those taxes eventually, depending on what their regular income is like, and how long they live, I guess, too, is the other issue.
I also know some very successful entrepreneurs who’ve decided to leave Canada, they’ll definitely trigger some AMT and may not be able to claim all the credits. It’s going to tend how they organize all the rest of their companies and everything else that they have to liquidate. The other wrinkle is that the provincial credits from paying AMT don’t change when you move provinces. It’s not just that if you leave Canada, there’s an issue. If you move provinces within Canada, you can start to run into some AMT issues where you may have paid AMT, but the credits don’t translate well to the province that you’re moving to. That can happen in a bunch of provinces. Particularly, if you moved to Quebec, they have their own AMT. The provincial AMT credits may not translate there at all. You may have a loss of all that prepaid tax that you made.
Ben explained this in more detail in Rational Reminder episode 304. It highlighted to me how complicated it was. I tried to take a stab at this one point. I eventually just gave up, because it was way more than I could handle. You definitely want to consult with a tax expert experienced with these issues if you’re facing one of these specific situations.
[0:34:43] BF: The interprovincial AMT stuff is pretty crazy. Federal AMT is calculated the way that I described earlier. Then provincial AMT is calculated based on a percentage of federal AMT in all provinces, except for Ontario, which is a percentage of federal AMT, but it also interacts with the Ontario surtax, which is from a modelling perspective, a nightmare. Anyway, that’s beside the point.
The interesting thing is if you’re in a high AMT province, that means that your provincial AMT in that province is a higher percentage of federal AMT, you’ll pay that high provincial AMT. Then if you move to a lower AMT province, you’ll recover your AMT at the rate in the province that you live in at that time. I think Newfoundland has the highest provincial AMT and Alberta, or BC, I think of the lowest, but it’s almost a 20%, or maybe it is a 20-percentage point difference between the provincial AMT rates. You could end up paying AMT at the high rate and then recovering it at a much lower rate if you were able to recover it. If you move provinces, or like you said, in Quebec, they have their own AMT calculation that is not a percentage of federal AMT, so it could just be lost in that case. Crazy stuff.
That relates to this decision of whether you should realize you’re deferred capital gains. That’s why we’re talking about AMT, because at this moment in time, a lot of people are interested in, “Well, okay, the capital gains inclusion rates going up, should I realize the capital gains on my taxable assets before the higher rate kicks in on June 25th?” Now, of course, the benefit of doing that is that you lock in the current lower inclusion rate on those capital gains, which is a tax savings.
The downside is that you’re pre-paying that tax that you might not have otherwise paid for many years, which is a loss of tax deferral. Yes, you’re paying tax at a lower rate. Awesome. But you’re paying tax now that you may have paid 30 years from now. The question becomes, which side of that trade-off is more powerful for your situation?
[0:36:43] MS: Yeah. I mean, looking at this problem, it really highlighted to me the power of tax deferral. It actually is quite powerful. The basic issue is that if you pre-pay tax now, you do lose not only that tax money that you just paid, you also lose all of the growth that would have happened on that money by keeping it invested. That impact actually compounds over time. It’s going to be a larger difference when there’s a higher rate of return, or a longer timeframe because that compounding growth really takes off.
The question becomes, which is worse? Paying a lower tax right now, versus a higher tax rate later, but on a bigger pile of money, because you’ve let more money compound over time? The answer is not readily apparent without modeling. I mean, our brains don’t work well with compounding.
[0:37:28] BF: The first thing that I did when this happened is went straight to Excel. Like I mentioned the beginning of this episode, I basically haven’t closed Excel since then. We actually had a web app out, I think, four days after the budget for people to play with online. Then we later added AMT to that. That was a personal capital gains calculator. We’ve got a corporate one, too. We’ll talk more about that later. I don’t know if we’re going to release that one to the public. At the personal level, this is pretty straightforward decision, which I think is why we were able to turn around a calculator so quickly. We can calculate what we called the breakeven horizon, where if you’ll be able to defer the tax bill on that taxable asset for at least that horizon, at least that number of years, you’re better off deferring the capital gain, even knowing that when you do pay tax on it at some point in the future, it will be at the higher inclusion rate.
We made a pretty simple model to show this online. I mean, it’s not a lot of inputs and it gives us a very easy output, which is just the breakeven horizon. We’ve got one on the PWL site. Mark, you also built one and it’s in the tax planning calculator section of The Loonie Doctor site. Lots of tools out there that people can use to play with this. We’ll link both of them in the show notes. That’s how people are thinking about this. That’s the obvious intuitive way to think about this. It’s that trade-off between tax deferral and tax rate.
As an example, if we’re sitting on a 1-million-dollar portfolio with a $500,000 embedded capital gain, in Ontario, the breakeven point is somewhere around seven or eight years. That means if you could defer the gain for at least that long, you’re better off not realizing the gain now because of the loss of tax deferral. That’ll depend on different things, like return assumptions and your personal income level. But ballpark, it’s around that zone. There’s an initial tax savings. If you look at the way this works out, there’s an initial tax savings. Initially, in year one, you’re better off realizing the gain before June 25th than after. That’s fairly obvious. Then the way that the after-tax wealth of the two scenarios develops over time is that the defer case has a higher rate of growth, basically, because of the tax deferral. There’s a crossover point where you’re better off deferring. That’s again, that’s the breakeven horizon, which in the case of a personal capital gain, we find somewhere around seven or eight years. Again, you should use your own inputs. But just as a general idea of the number, it’s somewhere in that range.
[0:39:47] MS: You take that modelling and translate it into something actionable. The common advice would be that personal capital gain situation, if you weren’t planning to sell before that breakeven point and don’t rush out there and try to realize your capital gains before June 25th. However, if you were planning to sell soon anyway, then it may be worth considering depending on the math for your specific situation. That’s the number part of it. I think beyond the math, there’s some other important considerations. When anytime you’re thinking about realizing capital gains, assets that tend to have large, chunky gains, they also tend to be relatively illiquid. Real estate or a business. You don’t want to just rush out and try to sell something like that before June 25th to save a little bit of tax, but then you lose a bunch of money on taking a compromise on the price or paying expensive transaction costs. It doesn’t make sense to do that.
There are also maybe some other options. We don’t really know all of these options, how well they’ll work until the legislation comes out, but there’s things you could try to do potentially, depending on what the rules are, like structuring a disposition over several years. For example, when you’re passing family property on to other family members, you may do that over several years to stay below that $250,000 threshold rather than just doing it in one big chunk. Or you could even, if you’re selling something, you could stagger payment and receiving that and have what’s called a capital gain reserve, where you receive the money over the course of several years, spread it out and stay below that threshold.
The legislation hasn’t been passed. We don’t know details about that. I don’t know how those strategies will work, but I would say that they all are going to have other costs with them, and there’s going to be other complexities to consider. I mean, there’s all sorts of gymnastics you can try to do, but yeah, you may have to pay more for that than what you’d save on the taxes. I think you need to be careful.
I think in summary, the best answer for personal capital gains is generally, to do nothing. I mean, unless you are planning to do it soon anyways, then it’s really easy to do. That’s a rule of thumb. That’s probably one of the few rules of thumbs that we’re going to be able to give today, but I think that is a pretty good one.
The unfortunate thing is I think we’ve seen that also being applied to corporations. This is by smart people. I’ve seen doing this as well. However, a capital gains within a corporation have other layers of complexity that are in there that could break those thumbs, if you’re trying to use rules of thumb.
[0:42:07] BF: Oh, yeah. You get your thumb dislocated. I don’t know. I’ve had that happen before. It feels really bad.
[0:42:12] MS: It’s not good.
[0:42:13] BF: No. On corporate capital gains, we can run the same analysis in a corporation and we did that. That was one of the first things that I did. I built the personal model and I built the corporate model with no personal consumption in the model, which is the key to modelling this. Intuitively, that’s what makes sense. You can build the same model. But as soon as you do introduce personal consumption, so that’s the need to pay salary and dividends out of the company to fund your lifestyle, which many people with corporations need to do, or are doing, the math changes a lot. Because instead of a breakeven horizon, although there still can be a breakeven horizon, but it changes a lot, but instead of a breakeven horizon, we can get a much more complex relationship that depends largely on the size of the gain and the amount of personal spending that needs coverage.
The reason that personal spending is such an important variable is that if you’re, for example, living off of a salary from your corporation, you’re paying lots of personal tax each year to receive that salary, especially if it’s a high salary. If you realize a capital gain in your corporation, you create a credit to the capital dividend account, to the CDA, which can be spent personally with no taxes. Oi, that’s one big piece, is an opportunity for personal tax deferral.
In addition to that, a lot of the taxes paid by the corporation on the capital gain are refundable when the corporation pays out noneligible dividends to shareholders. Again, if you have high personal spending and you’re taking the large amounts of dividends out of the corporation anyway to fund your consumption, that spending opens the door to releasing the refundable corporate taxes on the capital gain, which again, from the perspective of a breakeven horizon, that changes the math considerably, because all of a sudden, the net tax after the refundable portion on the capital gain is a lot lower.
[0:43:57] MS: Yeah. With personal capital gains, it’s largely a question of tax deferral on the capital gain. That favours not realizing the gain prematurely. That concept still applies to corporations. However, the other variables come into play may actually be larger than that tax deferral loss on the capital gain. Using the CDA to pay a tax for capital dividend could mean that you pay much less taxable income out to get the same amount of money that you can spend in your personal hands. Because you’re paying much less money out of the corporation, that means more money left in the corporation from the retained earnings. They can compound over time with that deferral of tax.
High personal consumption increases the magnitude and efficiency of that. Tax deferral increases on retained earnings, maybe much larger than the tax deferral loss from realizing that capital gain early. There’s a balance there. The second part of that balance really depends a lot on your spending and the size of the gain that you need to be able to move through the corporation. Now, there’s also a third big variable that comes into play. If you don’t use that capital dividend account to pay out some money and then boost your corporation’s deferral by not paying out as much regular taxable income if you instead use it to invest personally if you have an efficient personal investing option, that could be another way to do it.
Instead of easing that dividend, or your salary, or dividends, you invest it in your TFSA. Or if you make up for some unused RRSP room that you’ve got, those are tax-free types of investing and a corporation is even going to be exposed to some tax. We talked about that in episode 10. Now it gets tricky when you start talking about personal taxable investing, because an efficiently running corporation that’s moving the money out and paying the tax on the flow through, it’s pretty close to the lowest personal tax bracket. That’s pretty tough to beat, but those registered accounts, if you have unused room, this is an opportunity potentially to put some money in there.
Same thing can be considered with debt, too. When you pay back personal debt, if you’ve got troublesome debt that’s bothering you, you paying that back while you’re saving that interest moving into the future, you’re also not going to pay any tax on those savings that you’re making into the future, too. If you think about it as an investment by removing that liability, it’s actually a very efficient way of investing in what you’ve done, essentially. You’ve shifted some money from the corporation to a more efficient investing vehicle, and then using a capital gain and the capital dividend account is one way that you could potentially do that.
[0:46:35] BF: Yeah, I like it. Capital gain harvesting, this is the idea of realizing a capital gain to fund personal spending. Then that’s not a new concept. We talked about it at the beginning of the episode. You’ve written about it, Mark, Justin Bender at PWL has written about it, too. That’s something that at least within our bubble, which is admittedly a pretty small bubble, people have known about for a while. It was a sensible strategy even before this. To be clear, this is the idea of an intentionally realizing in your corporation, but it’s usually connected to a large near-term purchase, which is a little bit different from what we’re talking about now.
Harvesting your gain and distributing capital dividends and non-eligible dividends that trigger NRDTOH will generally be more tax efficient overall than just taking a big chunk of salary or dividends out of your corporation a single year to buy an RV, or something like that. Now, normally, and this is where what we’re talking about now differs from the traditional idea of capital gain harvesting, normally realizing a gain to realize a gain, if you don’t have a near-term purchase to fund, may not make quite as much sense. Because we’re in this abnormal time where we know that the capital gains inclusion rate will be increasing, that really changes the math on whether it makes sense to realize the gain that you would not have otherwise realized. Then we add in how realizing capital gain interacts with how you pay yourself from the corporation, I think it gets really interesting.
[0:47:56] MS: We’re going to dive into that modelling a little bit later in the episode. But I just want to start off with a little bit about the mechanics of actually doing this, because people get caught up in that. The mechanics of doing capital gains harvest is actually relatively simple. It’s the planning that’s the hard part about whether you should do it or not. That’s the tricky part. We’ve used this strategy multiple times over the years to fund home renovations and yes, to buy an RV, we’ve actually used it for that purpose. It’ll still be a useful strategy after the inclusion rate increases, but less so, because you’re going to have less of that capital dividend account available for you. There is a window of time to consider it depending on what you can plan on using the money for.
That planning part is complicated, but the procedure is relatively simple. Basically, you sell the holding with the capital gain and then you rebuy it. That way, you don’t miss time invested in the market. It’s not like you have to sell it in your account, take that money out and use that money from your investment account to eventually pay a capital dividend. It can be paid out of any of your corporate accounts. The key is realizing the gain in the investment account. When I do it, I stay invested, because I don’t want to miss time in the markets. It’s like the opposite mirror image of tax loss harvesting, where you try to sell gain things that have capital losses on purpose.
However, you don’t have to worry about the superficial loss rules. With the capital loss, you can’t buy the same thing back again. It has to be something that’s similar, but not identical. There is no superficial gain rule. You can buy back the identical holding. I usually do it in one sitting when I do decide to do this.
The other thing I would say is, if you were planning to rebalance your portfolio or make changes to your portfolio, do some different funds, or different investment strategy for good investment reasons, then this might be one of the times to do that where you sell some of your holdings, realize those capital gains, do your rebalancing that you’re planning to do anyways.
Now, the reason why there is no superficial gain rule is that you’re not deferring tax into the future. It’s not that advantage that they were trying to prevent with that rule. You’re actually triggering tax that’s due at your next tax filing. Governments like that, they would rather have money today than some time in the future for good reasons.
There are also other costs associated with it, too, though, that you need to think about. There’s going to be commissions to buy, or sell the equities, or funds, which should be minimal, or they might even be free depending on your brokerage. However, there’s still going to be a small amount of money that’s lost to the market makers from the bid-ask spread. Whenever you buy and sell something, there’s a little bit of invisible money that’s lost in that transaction. It’s usually negligible. But if you were frequently buying and selling stuff just to try to harvest tiny little capital gains, that cost would add up and probably make it not worthwhile. That’s why I’m mentioning it. It’s not something you would just do all the time.
I did say that I like to buy and sell on the same day, not to miss time in the market. However, with this, what’s coming up with this deadline, there’s this critical June 25th deadline that’s being talked about. One thing you have to remember is when you sell something, there’s going to be a time between you sell it and when the trade actually settles, and it has to have settled before that June 25th deadline. You may actually need two or three market days before then, which also depends on which days of the week things fall for things to clear before that deadline.
The other thing to think about is if you’re liquidating high-fee funds to try to move to a more cost-effective strategy, there’s often some time delay there between moving the funds from one brokerage to another brokerage, selling and settling the mutual fund sales before that deadline would be the key part. It’s the selling side of the transaction that’s going to be important for the June 25th deadline.
Overall, harvesting of capital gains is pretty simple. It’s a simple sell-and-then-rebuy transaction. However, there’s still more steps to fully process that harvested capital again afterwards. You have to reap the wheat, but then you have to do other things to it to get the money flowing out of it. That requires planning about how you pay yourself through your corporation with the help of your accountant. There’d also be a capital dividend, which is a special kind that tax re-dividend, which requires a special election, which are some forms and paperwork that need to be done that you should come with an accounting fee because you have to really make sure it’s accurate. There’s also regular dividends that you’d want to pay out to try to release the refundable dividend tax on the taxable portion of the capital gain. The fortunate thing is that you do have time to do that, and it’s usually going to unfold over several years if it’s a large capital gain.
[0:52:28] BF: One of the things that becomes really obvious really quickly when you model this is that optimal compensation is basically it. The reason we’re even talking about this is because it is built on the framework of optimal compensation. If you’re not thinking about optimal compensation, which is that was pretty cool, actually, as an aside, this whole conversation about realizing to further capital gain a corporation is interesting, built on the foundation of optimal compensation. Without optimal compensation, it’s just back to that breakeven decision.
[0:52:56] MS: No, it is. It’s actually how I started working on this. I was doing my optimal compensation model, and I discovered this way of thinking about it and I was like, “Wow, that’s very interesting.” Of course, around the time we were to spend money on something. Worked out really well. Yeah, the optimal compensation piece really underlies all of it. If you just blindly pay yourself salary, or dividends without thinking about your personal and corporate taxes together, then you’d never think of this thing.
[0:53:22] BF: You wouldn’t think of it. But even beyond that, if you realize a capital gain in your corporation and then just proceed to continue paying yourself a salary as you had been before, you’re making yourself worse off because you’ve just prepaid tax for no reason and gotten nothing out of it. You’ve got to be using that harvested money unless you’re using the harvested money to catch up on unused registered account room. That could be an exception there. Other than that, though, you’ve lost the benefit of tax deferral by realizing that capital gain and have not gained any tax deferral by retaining more money in the corporation.
[0:53:53] MS: You have to process it well.
[0:53:54] BF: You have to. It has to run through optimal compensation. Otherwise, we’re back to just the concept of a breakeven horizon and completely changes the decision-making process on this stuff. The other thing that we have to think about here is that a large capital gain in a single year may shrink the CCPC’s small business deduction threshold in the following year. That’s a whole adjusted aggregate investment income concept. We alluded to it earlier. It’s one of the ways that the Department of Finance has discouraged retaining too much money in your corporation. This decision interacts with that.
The impact of it is going to vary by province pretty significantly, which is something we’ll talk about in some of our cases. It’s going to increase corporate taxes payable on net active income. If you eat up all of your small business deduction limits with passive income, you’re going to pay more corporate tax. The other thing it does is that it creates a general rate income pool or GRIP. Anytime you pay tax at the general business rate, federally, you create GRIP. When you have a GRIP, you can pay eligible dividends to a shareholder. Eligible dividends at the personal level are more tax-efficient than non-eligible dividends.
When tax integration is working well, the net effect is an increase in corporate tax right away. That’s then attenuated later when dividends are paid out at the lower eligible dividend rate to a shareholder. Then the small business deduction resets the year after that. It’s always based on the previous year’s adjusted aggregate investment income. Exceeding the passive income limit basically incentivizes the owner to pay more money out of the corporation sooner. Importantly, when a corporation gets GRIP by paying tax at the general corporate rate, it does not create ERDTOH. That comes from receiving eligible dividends from another non-connected corporation.
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. This is the other interaction. Paying salary comes with other benefits, like RRSP room, or IPP room, and CPP contributions.
[0:56:00] MS: Yeah. I think we should explain the optimal compensation basics a little bit more because that’s really underpinning everything that we’re doing. Realizing a large capital gain also means that the income mix that you use to optimally pay yourself may change for a few years. You may be paying yourself a certain way at baseline, but to process this capital gain efficiently through your corporation, you’re going to make some changes over the course of a few years.
With a small capital gain or a large baseline level of spending, it may not change very much, or very meaningfully. However, if it’s a larger capital gain, or you normally spend less money, you’re going to have to start making some decisions about how you pay yourself. That’s going to change a little bit from year to year. We talked about choosing that optimal mix of salary and dividends in detail in episode 13. But if you want to just simplify the details of that strategy into some basic big steps, it’s that you would pay out enough dividends to release the value of your notional accounts first. The first thing would be, you’re going to pay out this capital dividend from the excluded part of the capital gain. That’s very efficient. You want to use enough eligible dividends to match the eligible dividends that your corporation is receiving. If you receive a dollar of dividends, you’re paying out a dollar of dividends and that refunds the eligible re-dividend tax to your corporation. Non-eligible dividends, it’s about 80%.
You want to pay roughly 80% of any of the interest, or foreign dividend income that the corporation received, and that would be enough to release the non-refundable dividend tax money back to the corporation. Clearing out those notional accounts with dividends would be the first step. Normally, that’s not going to be a lot of money for people that have a smaller portfolio.
Most people, when they have a smaller portfolio, or high expenses, they’re going to have to make a lot of that difference using salaries. That’s why salary is the base that people end up paying a lot of early on to fund that consumption. Then also, as you pay yourself salary, you’re going to generate some RRSP room and you want to make sure that you use that RRSP room. Since you’ve already paid the cost of taking a salary and paying taxes on it, you want to use that tax shelter room that you’ve generated. Basically, dividends to release those notional accounts and then a bunch of salary. That’s how it normally would work.
[0:58:17] BF: Let’s talk through the potential trade-offs here. When realizing a large capital gain, two things happen. There’s going to be extra NRDTOH generated from the taxable part of the gain. Plus, there may be some extra GRIP generated the following year if it causes the passive income limit to be exceeded and you have active income, which then gets taxed at the general business rate. If your personal consumption level is high, requiring a lot of salary and dividends, then paying out some extra dividends to release the NRDTOH generated may not shrink the salary requirement below the $175,000 roughly required to maximize RRSP room or the roughly $73,000 for CPP contributions.
However, with a really large capital gain, generating a big pile of NRDTOH, or if you have low personal spending, which requires relatively little salary, the amount of salary required after dividends have been paid out might drop when the dividends are used to clear out the NRDTOH. The capital gain is large enough. Say, it’s a $100,000 to $300,000 gross gain, then the passive income limits may generate some extra GRIP to move out. Depending on the province, that means either some extra dividends and less salary or sticking with salary while the value of the grip is eroded by inflation because GRIP is tracked in nominal dollars, as we talked about in a past episode.
One of the things that we’ve seen in our modelling is that to the extent that harvesting a gain does result in lower RRSP contributions due to lower salary, it ends up detracting from the overall performance of the strategy. It’s not to say that it makes it a bad strategy to realize the gain. In some cases, it still actually looks better to realize the gain. But the reduction in RRSP room does detract from the overall strategy. Still in that benefit, but missing out on RRSP room and contributions. Similarly, for CPP contributions, those are detractors of what can still be an overall successful strategy.
[1:00:16] MS: That’s a really important point. There’s a quantitative and a qualitative trade-off in this kind of decision. For example, quantitatively, that decreased RRSP size is often made up by having an increased corporation. In some provinces, it’s a very much increased corporation with a small decrease in RRSP size. It really depends on the situation. Both of those counts use tax deferral, too. How fast they grow relative to each other can be very close if the corporation is efficient, with lots of capital gains, or flowing through eligible dividends. It often does actually come out really close from a quantitative standpoint. The corporation has the advantage of being able to control distribution.
There’s some qualitative things that may come into play, depending on how you want to plan your drawdown strategy in the future. The corporation has the advantage of getting a little bit bigger from a harvest. RRSP is a little bit smaller. The RRSP will eventually convert to an RIF, so there’s going to be some forced minimal distributions, but they’re usually minor and you’re going to need money to live on anyway, so it’s a bit of a silly argument, honestly. It also comes with access to the pension credit.
Harvesting a large gain, we make a larger corporation, a smaller RRSP. What it does, though, is it concentrates more of the portfolio in the corporation. From a qualitative standpoint, we’ve seen a couple of times now that corporations are easier political targets for unfavourable tax changes, more so than RRSPs are. You are actually going to be taking a little bit more of that legislative taxation risk, potentially, by building a slightly larger corporation and a slightly smaller RRSP.
We’ve also focused on personal spending as the reason to take out money out of a CCPC and using a capital dividend to decrease the amount of taxable income required for you to live on. However, as we did mention earlier, using a capital dividend is also a tax-efficient way to fund a TFSA, or we pay some personal debt. Similarly, if there’s a low-income shareholder spouse, it may be possible to allocate the capital dividend to them, which shouldn’t trigger the TOSI rules, so those tax on split income rules that make it unfavourable, capital dividends don’t have tax on them, so it’s a bit different for Canadian citizens anyways.
This could allow them to invest the proceeds in their personal taxable account directly. If they’re in a low tax bracket themselves, that may actually be quite efficient. By doing that, if you are starting to build up a personal taxable account in addition to your RRSPs and TFSAs and corporation that again, helps you to diversify against that future tax risk. We’ve talked about the RRSP versus the corporation, but both of those are tax-deferred. If you have some after-tax accounts that are invested, that removes some of the tax risk for just taxes in general.
If you have a tax liability that’s going to be baked into a corporation, or RRSP, that’s going to be subject to changes in future tax rates. If you have less of that tax liability baked in because you have mostly after-tax money invested, then it helps to diversify that. In addition to the numbers, there’s this diversification of your tax risk factor that people probably should be thinking about.
[1:03:34] BF: Definitely. I mentioned earlier that provincial differences can be really important here. How well the strategy works, the capital gains harvest concept in a corporation is really dependent on province. Provinces with a really tight tax integration, like BC, it’s pretty close. It’s not a super obvious benefit. In all cases, there’s a big range of potential outcomes, but in BC, there’s not a whole lot of real slam-dunk cases. The scales can easily be tipped against harvesting with a large gain, with a low consumption level, and even more so after the inclusion rate goes up.
Now, with that said, in some provinces, there are current tax integration nuances that can further boost the effects of harvesting again in a corporation. We’ve talked with these anomalies before, but we’re going to put them in the context of this discussion. In Ontario and New Brunswick, there’s a beneficial anomaly that exists, which was created when the federal government sought to penalize too much passive income in a corporation. The intent was for the SPD threshold to get reduced due to passive income over $50,000. We’ve talked about that in episode 10. But the usual $500,000 SPD threshold shrinks at a rate of five to one when there’s a passive income over $50,000 in the corporation.
At $100,000 of passive income, that’s $50,000 over the passive income limit. Due to the passive income rules in the following fiscal year for the corporation, the SPD threshold shrinks by $250,000 from the usual $500,000. Any net active income over $250,000 gets taxed at the general corporate rate in this case. There’s a bump in corporate tax and income over $250,000 from about 12% to about 27% on active income. It’s a big jump, and at a five-to-one clip with rising passive income, can erode it pretty quickly.
With that shrinking SPD also comes the ability to pay out eligible dividends instead of non-eligible dividends. That savings from that can offset some of the higher corporate tax than with lower personal taxes, which is pretty interesting anomaly.
[1:05:36] MS: What happened in Ontario and New Brunswick is that the provinces didn’t follow the federal government’s passive income tax change to grind down the SPD. The federal corporate tax rate jumps as the SPD grinds down, but the provincial tax rate does not. The effect still accomplishes the goal. The goal is to incentivize CCPC owners to pay out more money from their corporations or face a tax jump. It still does that, but it uses a small care, instead of what the federally intended stick was planned to do.
Just to illustrate this as an example, let’s say, I have an Ontario corporation with $100,000 of passive income last year and $400,000 of active income this year, that first $250,000 because the SPD has been ground down federally, that first $250,000 gets taxed at 12.2%. The next $150,000 gets taxed at a hybrid rate of about 18.2%. That hybrid rate comes from 15% federal tax of the general rate because it got bumped up. But that 3.2% small business tax rate in Ontario stayed the same. So,15 plus the 3.2 equals 18%. If they had an income over $500,000, then anything over $500,000 is going to be taxed both federally and provincially at the general rate of about 26.5%.
There is this window of a blended tax rate between the shrunken SPD level and $500,000. This is where the interesting wrinkle comes in is that GRIP, which is that ability to pay out eligible dividends that helps to attenuate this effect, it’s actually calculated off of the federal rate. The corporate income has paid this hybrid tax rate of around 18%, but the corporation could dispense eligible dividends as if it had been taxed at that full general tax rate close to 27%. When you add that together, the net difference is about 2% less total tax in the top Ontario tax bracket. If you move down into lower tax brackets, the effect grows a little bit. It’s about a 5% advantage in the lowest tax brackets. If you look into Brunswick where the break was even larger, just because of the way that their tax rates are, it’s actually a 7% to 10% advantage into Brunswick. Quite substantial.
Triggering the small business deduction shrinkage with passive income from a large capital gain may actually be beneficial in some provinces, as long as you can move that money out. If you can move that money out, it’s a slight advantage, but if you aren’t spending that money out and you just try to keep it all in the corporation, then it is definitely still going to be a tax strike. It still accomplishes that goal of forcing people essentially to move money out of their corporations, but it could be a beneficial way of doing it.
[1:08:26] BF: Other interesting one is Quebec. It’s got less friendly tax integration anomalies. Instead of a little bonus, like we just talked about, it’s a bit of a penalty. There may be extra criteria to meet for corporations in Quebec, depending on the type of business, in order to get the SPD rate on any of your active income. For example, a professional corporation in Quebec must have 5,500 hours of employee work per year. That’s a maximum of 40 hours per week per employee. That translates to about three or more full-time employees. If you don’t have that, if you don’t meet that threshold, you don’t get any of the provincial SPD.
Then to make things more complicated, they do still get the federal small business rate. The tax rate on active income is a hybrid rate between the full general corporate and the full reduction of the SPD rate. That ends up being 9% federal and 11.5% provincial for a rate of 20.5%. Now, that’s less than the full rate of 26.5%, but it introduces this other wrinkle that’s pretty nasty that we’ll talk more about later. The corporation’s ability to dispense lower tax-eligible dividends is determined off of the federal rate. Remember, GRIP is always generated based on federal tax.
The Quebec small business owner, in this case, doesn’t get the Quebec SPD. Pay is a higher corporate tax rate, and does not make up for it with a lower personal tax rate on dividends, because they don’t get GRIP. Tax integration is broken in a pretty nasty way there for the corporate owner paying dividends for compensation in that case. The anomaly in this case works differently, obviously. It’s like an inverse of the Ontario and New Brunswick anomaly. But with the capital gains idea, eliminating the federal SPD allows the Quebec corporation to finally get its hands on some GRIP. It ends up being actually a good thing. Which lowers the overall tax is owing on income that’s retained in the corporation and then pass through as dividends to a shareholder.
[1:10:24] MS: It seems like a little bit of a reprieve if you’re flowing all of the money through, but the problem is dealing with the anomaly from a practical standpoint in Quebec actually gets a bit tricky. I spent the last week modelling this and it changes how we use our optimal compensation algorithm a little bit. On the one hand, getting bumped to the regular federal-provincial general rate gives a temporary reprieve from that unfavourable anomaly. However, that also depends on paying out the eligible dividends that are generated. If that’s at the expense of decreasing salary and RRSP usage, it may not be as good. RRSP and salary usage in Quebec is extremely important.
A model of our dynamic salary that we’ve talked about versus a dividends strategy, we would allow dividends to bump up and prioritize clearing out that GRIP like we would do normally. I did that versus a strategy that prioritizes paying out the salary and the dividends over using up that GRIP. Just letting that GRIP sit if you’re not able to use it. Now, I did it out to 30-year time periods and the strategies were extremely close either way. I would also say, the winner flipped back and forth based on small changes in the assumptions. I don’t think it’s a big deal one way or the other, honestly. I had to change my algorithm to something. In the end, I changed my optimal compensation algorithm for Quebec to prioritize using salary and RRSPs when there’s no access to the provincial SPD.
Mathematically, it comes out very close and flips back and forth all the time. I think with the advantages of an RRSP being a little bit safer from a tax standpoint, I gave the edge to that. If the Quebec Corporation has normal access to the SPD, then the usual dynamic salary and dividend mix that we’ve talked about before comes out ahead. But in this special situation where there’s no access to the provincial SPD, then the RRSP and salary just becomes a bit more important than I gave the edge to that. I had to use something standardized, so that I could test it using different strategies, like capital gains.
[1:12:30] BF: Let’s go through some case studies. I think this will help to illustrate how this could look in terms of process, but it also lets us compare the strategy results. Mark, you wrote some great blog posts with case studies. Let’s go through some of the cases that you have in your site. Then people can obviously refer to those as a resource as well.
[1:12:48] MS: I’m just going to stick with the highlights, the details and all the assumptions, and some pretty charts to illustrate key points are all going to be on the Loonie Doctor site. I started off with a base case in Ontario. This is the first case is an incorporated Ontario business owner. They earn $500,000 net active income in their corporation each year. That’s before paying out an optimal salary and the CPP that goes with it. Their business is eligible for the small business deduction. They’re single, so they don’t have external income sources from a spouse to offset their consumption needs. Everything comes through their corporation. They also don’t have a low-income spouse that could potentially invest, because that could also change the scenario. I’m trying to keep it relatively simple.
This person spends $150,000 a year on lifestyle. On top of that, they’ve maximized their RRSPs and they’ve maximized their TFSAs to date. That’s an important point because using a capital gains harvest to catch up on some of that unused sheltered room is a bit more of a slam dunk than this type of situation where they don’t really need the money. When you don’t have that attractive use, it’s a less clear dilemma.
When I’m going through my numbers, I excluded the existing RRSP and TFSA from the analysis just to keep things simple and to see the differences better. It does track new additions to those accounts. If you lose some RRSP room by the strategy, it’ll account for that loss. Now, in addition to their registered accounts, they have retained about $500,000 in their corporation over the years. They’ve invested that. It’s grown and their corporate portfolio is now worth a million dollars. They’re sitting on a $500,000 unrealized capital gain and they experience bouts of nausea and light-headedness listening to the federal budget announcements.
Looking past that visceral response, they still have plenty of runway before retirement and they’ve been investing and saving wisely up to this point. They also have an opportunity to plan for the upcoming changes. The question is, what should they do? It would really be wise to examine and weigh their options just to see if it makes a difference.
[1:14:52] BF: I think an important point when looking at these cases is that we can’t just look at a single year or even a couple of years. One of the things that I’ve noticed about tax projection, even really, sophisticated tax software, it often looks at one or two years, maybe four or five, but gains harvest has impact out much further than that. The long-term projections really matter when you start thinking about things like tax deferral, and then they’ll make a difference in how attractive or not a strategy looks in analysis.
In this case that you just described, Mark, in year zero, normally the shareholder would have used a $12,000 non-eligible dividend and a $7,000 eligible dividend to get the RDTOH from their usual investment income refunded to the corporation. In this case, they consulted with their accountant while planning the harvest and increased their non-eligible dividends to start efficiently clearing out the extra NRDTOH generated from the taxable half of the gain. In this case, it’s about $45,000 in non-eligible dividends instead of the usual $12,000. They also take a full capital dividend available due to the capital gain. For that initial year, they end up with $143,000 to invest in a personal taxable account after covering their living expenses.
[1:16:04] MS: The extra $33,000 in non-eligible dividends, it would not be enough to clear out all of the NRDTOH from realizing that $500,000 capital gain. Following the optimal compensation algorithm in year one, so the year after the gain was realized, the shareholder pays themselves with some more non-eligible dividends to release the rest of that NRDTOH. It actually takes a couple of years to clear out refundable taxes from the taxable half of that capital gain.
They also top up some of their spending needs using some of the money that they’ve had sitting in that personal taxable account. It’s relatively easy for them to access that and not take extra money out of their corporation and pay tax. They use that pot of money that they’ve got sitting there. The other thing is, too, we shouldn’t forget about this GRIP impact that we talked about. We realized a large capital gain and it completely eliminates the federal SPD the following year. That’s year one in our case. Because we’re also only using dividends because we want to clear out that NRDTOH balance, all of the active corporation income for that year one is going to be taxed at that general business tax rate federally.
Since we’re in Ontario, in this case, it still gets that provincial small business rate. The result is that we pay 18.2% corporate tax and still get that GRIP as if the corporation to pay the higher tax rates. We now have the ability to pay a bunch of eligible dividends out over the next couple of years.
[1:17:31] BF: That’s right. This is one of those favourable anomalies that we mentioned earlier. But it’s only favourable if the GRIP gets used up to fund personal spending. In this case, in years two and three, we’re clearing out the GRIP, covering spending from eligible dividends with a bit of an assist from non-eligible dividends that will just keep the NRDTOH flowing. Then after that, the next few years in the model show spending down personal taxable assets from the initial capital dividend. These are assets that – remember the initial capital dividend was larger than what was required to fund personal consumption, the difference was invested in the personal taxable account.
After a few years, they have accrued a small capital gain. Interestingly, remember, personally, there’s a $250,000 limit where you pay tax on capital gains at the 50% inclusion rate. In this case, in the model, the capital gain is well below that threshold. Again, in this case, with a small assist from dividends to keep the RDTOH from passive income flowing, we’re funding consumption from personal taxable redemptions, plus a little bit of those dividends. Then after that, there’s a transition back toward salary, which includes enough additional salary to max out the RRSP room generated by taking salary. That’s what it looks like in years four to six.
[1:18:46] MS: Yeah. I think this is why many people don’t think of this strategy, because it takes several years to unfold. As you mentioned, I mean, the software that a lot of people use doesn’t even do this thing, which is why we’ve spent so much time modelling it on our own. The net effect during that first seven-year window was if you look at the accounts, it was a slightly smaller RRSP and CPP because there was slightly less salary. However, there was a really large boost in the corporate retained earnings from paying out less taxable income, much bigger than what you lost with the RRSP. Plus, you’re also resetting that embedded capital gains tax liability, now your cost basis gets reset, so it starts to accrue that from our fresh start moving forward.
[1:19:28] BF: There’s a boost to the investment portfolio, but also a change in the portfolio’s composition. THAT means that there are longer-term impacts to consider. At the 20-year horizon, we see that the overall portfolio value in the case of realizing the gain and using the capital dividend account to fund spending outpacing that of deferring the gain, which is what we’re looking for here. In Ontario, that was due to the boost in corporate retained earnings from using capital dividends, plus the efficient outflow of eligible dividends from the SPD passive income anomaly. This is very different from a case with no spending, where after 10 or 11 years, we generally see deferring coming out ahead for a corporation. Optimal corporate compensation strategies really added an important layer to this whole decision-making process.
[1:20:11] MS: You mentioned that the portfolio composition is a bit different. That is also important in terms of how much exposure you have to the other task risks, which we’ve talked about, I think repeatedly. I think we’re all maybe fresh from the budget. But harvesting a capital gain, paying tax now and flowing it through resulted in this simulation in $216,000 more in the corporation and $159,000 less in the RRSP at year 20. The boost to the corporation was actually much larger than the RRSP. When you count for the taxes in there, we came out to a $57,000 advantage from harvesting a $500,000 gain and doing some compensation planning. That’s after liquidating the portfolio, and it’s also an inflation-adjusted real dollars. That’s a pretty big difference just based on some planning and strategy manoeuvres that you could do.
Now, most of us would not liquidate our portfolios, but that’s a standard way to discount for the embedded tax liabilities. Most of us would draw down our portfolio more gradually over a period of time, hopefully, at a slightly lower tax rate. That would magnify the impacts of tax deferral when you do that. I looked at that as well. With a corporation and RRSP, both of those use tax deferral and interestingly, the balance of that in our Ontario scenario with a much larger corporation actually magnified the harvesting advantage, because you had so much more money in the corporation, it’s tax deferred, and then over the long run, that actually magnified the impact. It’s pretty cool.
I mean, it sounds like it’s a slam dunk. It was pretty good in this exact scenario that we just went through, but that is not always the case. If it’s more money, assuming that the corporate taxation isn’t specifically targeted along the way, too. If we’re looking at long timeframes into the future, there’s always a risk that the tax rules change again. We’ve now made a corporate portfolio that’s a little bit bigger than RRSP, so we’ve concentrated some of that risk. I don’t know. Some people may feel that the big boost in potential after-tax money is worth that. Others may not. I think, there’s a subjective component that has to enter in into the discussion.
There are also some numerical components, like the size of the gain relative to the amount of money required to spend personally is also important. For example, if the corporate owner in our case only needed $100,000 a year to fund their spending, either due to low consumption, or a spouse with outside income that’s supplementing their lifestyle, then there would actually be a slight disadvantage to harvesting that large $500,000 capital gain. It would just take too long to work through all of the notional accounts that are generated efficiently. It could even shift back gain to be an advantage, too. If you get to really low levels of personal consumption, where you’re able to invest some of that money personally at a really low tax rates, then it could actually shift back to an advantage again, potentially. It all depends on how you’re using that money.
This actually got me pretty excited, because I was able to make my very first 3D Excel chart. I didn’t know how to do this, but I made this 3D chart and a plots consumption versus the capital gain size on the flat horizontal plane. Then the advantage or disadvantage of a harvesting a capital gain is the vertical axis. For Ontario, there was this really neat-looking topographical mountain, which most of the mountain is above water. There’s often an advantage at different levels of capital gain and different levels of consumption for Ontario, and I’ll put that into a chart before the podcast, we could put something on my website.
Really though, even with that 3D chart, this really needs a 4D, or a 6D chart, because there’s other important variables that involve, like province, which you’ve mentioned, baseline corporate passive income levels, because if you’re having to pay out a bunch of dividends regularly just to keep the passive income moving, it doesn’t give you as much wiggle room. There’s investment and returns that influence the outcome and then also, your future drawdown plans, which I mentioned as well. The point here is that the sensitivity of the results to different situations really, to me, it emphasizes that this requires thought and advice for your specific situation. There’s not just some rule of thumb you can apply.
I mean, some provinces tend to be better than others for this, but you really want to consider this. It requires broad discussion thinking over multiple years and thinking about your tax plan and your financial plan together, which is probably why it doesn’t happen that much.
[1:24:39] BF: Maybe this is just a shameless plug, I don’t know. But I don’t know how many places you could go to get advice on this right now. I really don’t.
[1:24:46] MS: Yeah, not many.
[1:24:47] BF: Except PWL, obviously, and Mark’s website.
[1:24:51] MS: Yeah, pretty much.
[1:24:52] BF: That was my shameless plug. That example was for Ontario. We’ve mentioned that the province makes a big difference. In provinces with tight tax integration and no passive income SPD anomaly, like Ontario and New Brunswick anomaly that those provinces have, not excluding those provinces, it can be really close. For example, you did a follow-up case with the same parameters exactly, but in this case, it was in British Columbia, instead of in Ontario.
[1:25:18] MS: Yeah. The results were ironic because it’s British Columbia, but my 3D chart for BC actually looked more like a floodplain compared to Ontario. It was pretty flat and many of the scenarios were slightly underwater. With the same portfolio and $150,000 a year of spending and that $500,000 capital gain, it was generally better left alone in BC. Even how you look at the results change that’s a little bit too, like it was $16,000 less after-tax money if the portfolio were liquidated at year 20. If you drew down more slowly, because you get a little bit more extra corporate tax deferral benefit, it was actually a little $9,000 more by doing the harvest and having a bit more money in your corporation. It really depends on how you look at the results.
Honestly, I think it’s so close that I don’t think it really matters either way in that situation. Plus, there’s also those issues of shifting money into the corporation and away from the RRSP, which I wouldn’t want to do that unless there was a clear advantage. Quebec is also interesting with this unfavourable SPD anomaly. The tax integration favouring salary and RRSP usage there is so strong that harvesting a capital gain without normal access to the Quebec SPD was often suboptimal because you’re losing some of that RRSP and salary room, even with the change to my algorithm. That’s using the same parameters I used for the Ontario cases. But the cases, whether there’s a small capital gain, or there’s some low tax personal investing option, then it can actually be very close to potentially an advantage again. Again, it’s very situation-specific.
In Quebec, when there was normal access to both levels of the SPD, then there was a modest advantage again to harvesting a capital gain early. What the parameters I’d used is about $20,000 to $50,000 on that $500,000 capital gain. Significant money for doing some tax planning. Again, I would caution that the outcome is sensitive to how much you spend, how efficiently you process the harvest again.
[1:27:19] BF: These are also accumulation cases. That tends to mean, higher incomes, active corporate income, less access to dividends splitting for most business owners. During retirement, dividends help to clear the notional accounts. Income splitting over age 65 helps to make that even more pronounced because you’re paying less personal tax for the same amount of dividends. Capital dividends are not taxable income for determining OAS claw back. It’s another really important point. A different set of variables, really, when you’re thinking about it in a retirement context.
Now, I know that you’ve been working on this with your model, Mark. I’ve also been plugging away at it, but I don’t think either of us had time to build a full retirement projection into our models before recording this.
[1:28:00] MS: No, not yet. We were joking at the beginning about how this modelling has become an obsession. It was actually hard to tear myself away from coding it, to sit down and write this episode. I do think this is information we needed to get out for people to digest. I know you’ve been thinking about this at PWL with your clients as a strategy for years. I’ve used it for quite a while as well. I think one of our goals with getting this information out there is it would be great if more advisors and more people that provide advice to people in these situations start thinking about optimal compensation and thinking about these types of strategies. It just opens a whole new level of value that people could provide to their clients, without a lot of extra costs other than the time to plan, which is what you’re paying people for anyways.
I tried to put some stuff out there for free on my website to get people thinking and to have these discussions. I think we really need to try to get that information out there. We did feel a bit of pressure to come out and say this, even though the legislation hasn’t passed yet, people need to digest some of this information. I’m hoping that it’ll help to change the way that people think about some of their financial and tax planning, regardless of how the legislation actually unfolds. We are still working on it. Just keep checking in, but I think that’s important.
I know we’ve talked a lot about the taxes and the numbers. I do think it’s important to acknowledge. I know there’s a lot of people that are upset about the tax changes. It’s concerned a lot of people. I mean, it’s obviously an effect more than the 0.13% that the government’s suggesting that it’s going to impact. It’s going to affect more people than that. Putting that political rhetoric aside, I think the most important question for individuals is whether this will have an impact on their own retirement plan.
Ben, I know that the PWL team has been fielding lots of questions from concerned people about this. I know that you’ve been modelling it. Can you give us a bit of a sense of what type of impact we might see from this?
[1:29:56] BF: I think this is really important. I don’t want to minimize how impactful this can be to people in some situations. There’s been so much rhetoric around it that it’s been hard to figure out what is signal and what’s the noise in terms of the actual impact on people’s retirement plans. Even with the strategy we were just talking about, when we find an optimal strategy, it’s not like it’s going to double your net worth. We’re talking about relatively marginal improvements and even the best cases. I think that shows up in what we’re going to talk about next, which is really, how does this impact retirement planning for CCPCs? Like you said, that’s really what people are worried about. Is this going to affect my retirement? Or to what extent is probably the better question? Is this going to affect my retirement? Because it will. But, I think while these changes are meaningful, the impact on retirement spending is not actually that significant.
Now, there’s still a large impact on a state planning, where tax in the final disposition of assets are going to be hit with a higher capital gains tax. On actual retirement planning, how much can you spend? How much can you afford to fund in your retirement. Not as big of a deal. One of the first things that Braden and I did when the budget came out, other than building the breakeven calculators was to run a retirement simulation in our research model for a case with the current and the proposed inclusion rates. Our research model is just Python code. It doesn’t have an interface. We ran a case study for a 30-year-old with 1 million dollars in a corporation today, with a cost base of $500,000. They’re earning $300,000 a year of active business income. They’re spending $177,000 per year personally, and then they’re saving the difference in their corporation.
Then we ran these two scenarios side by side at the current and proposed capital gains inclusion rates, which is calculated the sustainable spending rates in retirement for each scenario. What we found is that sustainable spending dropped by $4,800 per year under the new rules. Instead of being able to maintain that $177,000 per year, they had to go down to $172,200 per year to maintain their success rate in probability simulations. That’s a 2.7% drop in sustainable spending in that case.
We didn’t publish anything on that, because our research model is really an internal tool that we use to test ideas before we build something more substantial behind them. More recently though, Mark McGrath, who’s also at PWL, he ran a case in Conquest Planning, which is one of the financial planning softwares that PWL financial planners use. It’s probably the best financial planning software on the market right now. They’ve rolled out the ability to switch between current and proposed capital gains inclusion rate in their software.
Mark did a similar case study. He created a hypothetical scenario and compared the outcomes under the old and proposed capital gains inclusion rates. Mark had a 30-year-old physician. They’re earning $400,000 annually. She’s paying herself a salary of $165,000 per year, plus an additional $50,000 per year in dividends. She’s increasing the amount of dividends over time to clear out the notional accounts in her corporation as they accumulate. She needs $120,000 in after-tax income today to meet her needs. Then when she retires at age 65, she needs $150,000 per year of after-tax income. Along the way, she’s maxing out her RRSP and TFSA each year. Inflation in the model is 2.5% throughout the whole projection. All of her expenses are indexed to inflation, but her revenue and salary are not indexed in this model.
She takes CPP and OAS at age 70 and lives to the age of 95. All investments in her corporation are invested in a global equity portfolio with an annual expected return of 5.91%. In this case, under the old capital gains rules, she passes away at age 95 with a net estate value of 4.36 million dollars in today’s dollars. Under the new rules, the estate value drops to 4 million dollars. that’s a $360,000 reduction in today’s dollars. An 8.25% reduction in her terminal wealth, purely attributed to the increase in capital gains taxes.
[1:33:58] MS: Yeah. I think when thinking about terminal wealth and estate planning, what you plan to do with that money is also important. For example, if my plan were to pass it all on to my family, either at death or even gradually before death, then that reduction could be meaningful. However, if my plan were to donate most of it to charity, the capital gains to change would not really have a significant impact, because it’s charitable donations. I mean, yes, there’d be less capital dividend money to pass up a family, maybe if they changed rules.
Although, right now, if you donate to charity, the whole capital gain goes to the capital dividend account. It would really, really lessen that impact if I had big charitable plans. When you donate appreciated stock to charity, the entire capital gain goes to that capital dividend account, so these inclusion rate changes don’t really actually apply to that situation. I think the impact would be much less than if I was planning to donate a lot to charity, rather than pass it on to my family. I do think the biggest impact though is whether people have this risk of running out of money while they’re alive. That to me would be the big concern.
[1:35:05] BF: Mark also ran the Monte Carlo simulation with a thousand trials for both of those scenarios and looked at it from that perspective exactly. We found under the old rules at age 95, in his case, 661 of the trials were successful. She was able to sustainably cover her retirement expenses 33.9% of the time. Then under the new rules, that dropped to 35.8% of the time. She was unable to cover her expenses. There was a 1.9 percentage point decrease in the success rate.
What we see here is that the median wealth result is a pretty significant reduction to her terminal wealth, but her ability to meet her retirement goals in this case is not really dramatically reduced, which is similar to what Braden and I found in our initial pass at this type of analysis. I think the explanation is pretty simple. It’s just that retirees are not realizing all of their capital gains every year. Even with a corporation, the marginal impact on your consumption, as we’ve seen, it’s relatively small, because it’s not like a 100% of your income is coming from a realized capital gain every year. It’s going to tend to be a relatively small proportion of your overall stream of income. Ideally, people are deferring their capital gains as long as possible and realizing relatively small amounts each year along the way and taking out the right types of dividends to release RDTOH and all that stuff. Not a huge impact. An impact, but not as big as I think a lot of people may have thought initially.
[1:36:32] MS: The other thing I thought looking at those results, when you take them together, I thought it was a bit interesting. My initial thought was 4 million dollar at death. Geez, boo-hoo, big deal. Who cares if somebody has a slightly smaller multi-million-dollar estate? However, I think what isn’t appreciated by many is that the sequence risk is a big deal and applies to real life. When you look at it differently from that Monte Carlo type of simulation, it’s not the same.
This is mitigated for people that have group pension plans. However, for a self-employed person and/or anybody without a group pension plan, they take on a lot of that risk themselves, which means they have one of the ways they can try to deal with that is to over-save upfront, try to mitigate it. You may end up, it turns out well and you end up with this big estate, but there’s also a 36% chance of not being able to sustain your spending. That’s actually not a small risk to me. If it turns out well, great. If it doesn’t, there’s this chance of running out of money and it’s not even close to being zero. That was interesting. I mean, numbers can tell us all sorts of stories, but they don’t always capture everything.
[1:37:36] BF: Totally agree. All right. I think we’re getting close to the end of our procedure here. I think this is the really important part. What should you do with all this information? We do hope that exploring the potential impacts of the proposed capital gains, inclusion rate changes in today’s episode, along with some stories and numbers has helped you think through what’s going on, what the implications are of different decisions. We hope that it’s helped to stimulate you to consider some of the issues and deter you from making any rash decisions. We also hope it’s motivated you to raise and discuss the implications of your own situation with your professional team and your family and whoever else may be affected by these decisions.
This episode is planned for release on May 31st. The increased capital gains inclusion rate starts on June 25th under the budget proposals. At the time of recording, though, we’re in this weird limbo where nothing related to the capital gains inclusion rate proposals has actually been passed into law. Deputy Prime Minister Freeland has said, that we will have draft legislation before the House of Commons goes on summer break. The House sits until June 21st, which is a Friday. If they wait until the last minute and we get draft legislation on the Friday, that’s probably too late for most people to actually do anything with the information. We’re in a really tough position, unless they come out earlier with information. We have nothing to go on right now.
[1:38:52] MS: Yeah. I mean, as of now, there is no draft legislation. We don’t even have an idea of what the final legislation might look like. I mean, this really puts Canadian taxpayers in an awkward and difficult situation. We’ve seen this actually happen several times over this past year at the underused housing tax and the bear trust issues. I mean, this tax uncertainty makes planning difficult and can make people accrue all sorts of costs and make decisions based on not having information, or the information changing unexpectedly once it starts to pass through the system. That makes me concerned.
However, I would say that thinking about this in advance and thinking about the variables of play for you is still going to be time well spent. You could think about things like, the power of tax deferral, adding that layer of optimal compensation and potentially, even capital dividends to how you pay yourself from your corporation. Those are all things that they were important before the proposed changes. There’s still going to be things to be concerned about and thinking about after the changes as well.
[1:39:56] BF: That’s right. I’d be super mad if I didn’t like modelling this stuff so much.
[1:40:01] MS: I built the model, so that I can just change a couple of things.
[1:40:06] BF: That’s the way to do it. Despite this awkward situation, we don’t really know what’s actually going to happen. We don’t know what the legislation is actually going to say and what planning is going to make sense. I think there are some things that we can suggest even in that situation. If you have a large near-term purchase that you were planning on making personally anyway, or if you need to catch up on large amounts of unused registered account space, harvesting a capital gain in your corporation to shift money out tax efficiently is advice that we would have given, even if they were not a looming potential increase in the capital gains inclusion rate.
We had an episode planned on that, or at least an episode plan that would touch on that, we just haven’t gotten into it yet. We’re getting to it now. But the important point there is that we would have given that advice anyway, without this looming potential change. If you’re in that situation, executing on that planning before the new inclusion rate kicks in is a pretty, I think, obvious decision.
[1:40:57] MS: I definitely want to run up by your own advisors to make sure that everything aligns, there’s not some nuance that you’re missing. Because as we’ve said, it’s really complicated. But I think it is worth thinking about, particularly one of those situations where this is advice that would have worked out before if people have thought about it. If you don’t have a major purchase planned, the equation that it does become more complicated. I made a corporation capital gains tax change similar to my site people can use. We’ve mentioned that that’s part of what we use to use the, do the modelling, as well as Ben’s simulator as well to make sure that we all line up, as adjustable inputs for the main variables that we’ve talked about, models different strategies using the optimal compensation algorithm. It’s meant for you to initiate some discussion and planning for your own specific situation, if you’re with your own advisors, or whoever you normally consult with when making these types of decisions.
Given how complex this information is and it’s new to many people, even advisors, you need to come to the table as an educated client to talk about some of these things. Don’t just rely on the fact that you think your advisor is going to think about it and bring this up if it’s appropriate for you. They may not have thought about it. Understanding a bit about this and using some keywords, like realizing capital gain and using the capital dividend account to spend money personally and maybe take less money out of the corporation for a couple of years, or to invest personally, if that’s efficient, using some key phrases like that when you’re discussing this with your advisor, I think is important. I hope that’s one of the main key messages that you come away with.
[1:42:30] BF: We have also built a web application similar to our personal tool. It’s actually a toggle where you can just switch between personal and corporate in the one that we already built. We have not released the corporate module to the public yet, but it’s similar. It answers the same question. We’ve been cross-checking our results and testing scenarios to better understand the nuances. We’re pretty comfortable that we’re at least both in the realm of accuracy where we want to be. We may release a version of that to public use, not a 100% sure what direction we’re going to take with that yet, but we are using it internally now.
In any case, this can be a complex decision. It shouldn’t be rushed. We still have time before the proposed deadline kicks in. Hopefully, we get at least some draft legislation before then. Even though the timeline is tight and there’s a lack of specific information that’s made this all more difficult, we hope we’ve set people up to make some half-decent decisions.
[1:43:20] MS: Thanks.
