Capital gains taxation in Canada

To draft this article, I drew inspiration from a research paper prepared in 2018 by Chaire de recherche en fiscalité et en finances publiques (the research chair in taxation and public finance) at Sherbrooke University.

Capital gains are a type of income that is generated when you hold investments in a non-registered account that accrue in value. This type of income was, for a long time, not taxed. In Canada, taxation on capital gains was introduced in 1972 following the recommendations of the Royal Commission on Taxation (the so-called Carter Commission, named after its chairman) and based on the argument that “a buck is a buck is a buck.(1)” In other words, while income may be generated in various ways, it remains income and should be taxed in the same way. Along with property tax, capital gains tax is one of the very few methods in Canada for applying taxation to wealth.

It’s worth noting that, following the introduction of the capital gains tax in 1972 in Canada, gains made prior to this change in taxation policy were exempt from taxation as a result of a transitional rule whereby only realized gains achieved after January 1, 1972, were subject to taxation. The inclusion rate—that is, the portion of realized capital gains to be included as taxable income—was set at 50%. The rate remained the same until 1987. In June 1987, the federal government announced that the inclusion rate would be raised from 50% to 66 2/3% in 1988 and to 75% for the 1990 fiscal year and subsequent years (2).

The inclusion rate remained at 75% from 1990 until the year 2000, when, as part of the federal budget, it was rolled back to 66.67%, effective on the date in February when the budget was tabled. In that same year, the inclusion rate was once again reduced as part of the economic statement of October 2000 to 50% (3). Consequently, the year 2000 saw three different inclusion rates, with the period in which particular capital gains were realized determining which rate applied. Since October 2000, more than 20 years ago, the inclusion rate for capital gains has remained at 50%.

It’s worth noting that since the introduction of the capital gains tax, all provinces have used the same inclusion rate as that of the federal government.
There is no consensus among experts on the impact of capital gains taxation on economic activity.

Another noteworthy change in capital gains taxation occurred in summer 1985 with the introduction of the lifetime capital gains exemption (LCGE) of $100,000. The exemption applied to each taxpayer’s cumulative lifetime gains and was explicitly designed to encourage individuals to invest. The exemption was to be implemented gradually over a period of six years, with a ceiling of $250,000 in taxable capital gains (that is, $500,000 in gross capital gains) in the course of the sixth year and in subsequent years.

In 1987, the federal government put an end to general exemption growth by setting the cumulative limit to $100,000 of capital gains (that is, $50,000 of taxable gains). Since then, the top limit of $500,000 has applied to agricultural growers and small-business owners.

In 1994, the federal government did away with the general $100,000 LCGE, but left in place the exemption for agricultural growers and small-business owners.

In the pre-budget consultation periods leading to the 2016 and 2017 federal budgets, faced with the gap between taxation rates for dividends and capital gains, various commentators raised the possibility of increasing the capital gains inclusion rate, but nothing ever came of it.

Inclusion rates in other countries, however, may soon undergo changes. In November 2020, the United Kingdom’s Office for Tax Simplification published a new report (4) on revamping the capital gains taxation system in that country. The report suggests that harmonizing capital gains tax rates in the U.K. with general income-tax rates may generate considerable revenue for the government. The tax cost of selling an investment with inherent gains may double. In fact, as reported by The Financial Times (5), some executives in the United Kingdom may be getting ready to sell their investment holdings in their own company to avoid having to pay higher capital gains tax in future.

In the United States, too, changes may be made to capital gains taxation to bring it in line with President Joe Biden’s platform. Currently, the U.S. taxes short-term gains (sale of assets held for less than one year) at an ordinary rate ranging from 10% to 37% at the federal level. Long-term capital gains (sale of assets held for more than one year) are taxed at a more beneficial rate ranging from 0 to 20% (excluding the additional net investment income tax of 3.8% that applies to high-income taxpayers).

President Biden’s proposal would result in an increase in capital gains tax by treating capital gains as ordinary income in the case of taxpayers who earn more than US$1,000,000 a year. In combination with his intention of once again raising the top ordinary income-tax rate to 39.6% (up from 37%), the increase in capital gains tax would almost double the long-term capital gains tax rate, raising it from 23.8% (20% plus 3.8%) to 43.4% (39.6% plus 3.8%) for high-income earners.

What is the situation in Canada? As part of the government’s pre-budget consultations held from February 3 to 6, 2020 in Ottawa, leading to the 2020 budget update, the Standing Committee on Finance heard proposals from more than seventy organizations and individuals. It also received more than 270 briefs. In its final published report, the Committee recommended that neither individual income-tax rates nor the capital gains inclusion rate should be increased.
However, if we are to believe some of the 800 hundred or so submissions received by the government as part of its pre-budget consultations leading to the 2021 budget (6), this view may change given the government’s unprecedented level of expenditure resulting from tax-relief measures for individuals and businesses implemented in response to the COVID-19 pandemic. In 2020-2021, the deficit may rise to $400 billion. We will get to the bottom of this on April 19 with the tabling of the federal budget.