Taxes on Capital Gains
Capital gains tax is the amount owed when capital property gets sold for more than it was paid for. This tax doesn’t apply to all gains, though. Only one half of the gain is taxable. Here’s an example. If you buy 10,000 shares of a company for $50,000, the adjusted cost base is $50,000. Then, you sell those same shares for $100,000 which means you have earned a capital gain of $50,000. Half of the gain, $25,000, goes towards taxes and is known as the taxable capital gain.
Keep in mind, not all sales result in capital gain. You might sell a property for less than you bought it for, or less than its adjusted cost base. This is considered a capital loss. Luckily, capital losses can be used to reduce capital gains within the same year. You can also use half of your capital losses for the year to offset capital gains in the three years prior and carried forward to offset future capital gains with no time limit.
Let’s say in the same year you bought those 10,000 shares, you also bought 1,000 shares from another company for $50,000. Then, you sold them for $40,000 which means you received a capital loss of $10,000. For the year overall, your total capital gains would be $50,000 minus $10,000 which equals a total capital gain of $40,000. The taxable capital gain amount would be half of your capital gain which is $20,000.
When you pass away, the movement of your assets, real estate, and shares is treated like a sale which means there will be a resulting capital gain. There are different strategies you can use to defer or reduce capital gain tax when you die so that your loved ones aren’t left with the bill.
Taxes on Different Types of Dividends
The profit a business or investment earns is considered a dividend and gets distributed to the shareholders. The amount shareholders receive is taxed at a lower rate than employment or interest income as long as the corporation holds residency in Canada. This is because the corporation has already paid tax on the income it earned and used to pay dividends. Credit for taxes already paid at the corporate level is provided through a specific mechanism. This process is called the Concept of Integration. Individuals should pay approximately the same amount of tax whether income is earned personally or corporately and the after tax profits are distributed as a dividend.
There are three classifications for dividends. They are eligible, non-eligible, and capital. Each classification uses tax rates that reflect the taxation within the corporation as well as the amount of tax that would be paid if it was earned personally. A Canadian Controlled Private Corporation (CCPC) gets a lower tax rate at the start of its life. For its first $500,000 of income, the tax rate is 12.2 percent and then after it’s 26.5 percent. Ineligible dividends come from income that was taxed at the lower rate and eligible dividends come from income that has been taxed at the higher rate.
Public companies and private corporations most commonly give eligible dividends. These entities have a general rate income pool (GRIP) which represents the income that was taxed the higher rate. These dividends reflect the income the corporation has earned, so they receive an enhanced dividend tax credit with the higher rate of tax. Eligible dividends are taxed using the lower rate when individuals receive them.
Ontario’s top marginal tax rate on eligible dividends: 39.34 percent.
When private corporations pay the lower tax rate on the first $500,000, non-eligible dividends are received. These dividends are provided with a lower dividend tax credit since the corporation has paid less corporate tax, and also grossed-up to reflect pre-tax corporate income.
Ontario’s top marginal tax rate on non-eligible dividends: 47.74 percent.
Half of a corporation’s capital gain is taxable and the other half isn’t. Instead, it gets added to the capital dividend account (CDA). When a corporation receives a death benefit, they receive a capital dividend credit. However, this credit is equal to the difference between the death benefit and the adjusted cost basis of the insurance policy. It’s crucial for corporations to track their CDA because these capital dividends can be dispersed tax-free. In estate planning, paying capital dividends can reduce the tax liability from the disposition of shares upon your passing.
Estate Related Taxes
Estate tax doesn’t exist in Canada, unless you include the provincial probate tax. We do have taxes that apply upon death that relate to the disposition of the deceased’s assets. According to Canadian tax law, it’s assumed that the deceased has disposed of all their assets before death. So, someone whose assets have grown in value may have tax liability that needs to be funded. This is similar to the rules surrounding registered assets (ex. RRSPs) in which fair market value of each asset must be included in one’s income upon death.
Private corporation owners face problems when it comes to deemed disposition on death. A company that has immense value will likely have capital gains tax to be paid. Although a tax is due, there wasn’t an actual sale of shares. The disposition of the company only implies there was. So, the company may not have the funds to pay this tax. That’s why it’s crucial for business owners to plan for this tax well in advance.
There’s an exception to the deemed disposition process when an individual leaves capital property or assets to a spouse or spousal trust. This is a planning strategy in which the capital gains tax is deferred until the spouse passes away or the property is sold. At this time, the executor of the deceased spouse submits an income tax return for the year of death. This return includes the taxable income earned in the year leading up to their death. It includes gains from the deemed disposition rules. In some cases, it’s possible to file separate returns for certain types of property such as rights or things benefiting from marginal tax rates. The estate will also need annual tax returns filed that abide by the tax rules for graduated rate estates.
Tax Issues for Business Owners
Small Business Deduction and Passive Investment Income
Canadian Controlled Private Corporations are sometimes entitled to the small business deduction (SBD). This is when the company’s first $500,000 of income gets a lower rate of tax; currently, the federal tax for this type of income is 9 percent. Provinces also offer a lower corporate tax rate for CCPC’s income to a specific amount.
What’s the purpose of this rate reduction? To allow more corporations to retain more of their income so they can continue to grow in the future. Unfortunately, this retention is recaptured by the government when ineligible dividends get taxed at higher rates than eligible dividends. The goal of the government is to ensure income tax paid by corporations and distributed as dividends equals how much the business would have paid in tax had the income been earned by the shareholder directly.
Passive investments such as shares in public companies, real estate, and mutual funds became a concern to the federal government since they were not being used in the business. The government of Canada wants to prevent shareholders from receiving a tax advantage on income that qualifies for SBD but was invested in passive investments. New legislation reduces the amount of SBD-eligible business income when the passive income from the previous year exceeds $50,000. This means that a CCPC could have their business limit decreased by $5 for every dollar of investment income above $50,000. The business will lose the SBD limit when investment income is more than $150,000.
These changes make it crucial for CCPC owners to track their investment income in order to avoid the SBD reduction. Business owners may consider shifting to passive investments that provide capital gains. Half of the gain is included in the investment income category. Another consideration would be to make use of tax-free corporation owned life insurance policies. Income earned within this channel is not considered investment income per these new rules. By purchasing a cash value policy, they don’t impact their business limit for SBD. However, it’s strongly recommended to consult with expert tax professionals when implementing these strategies.