Portfolio Strategy

Thinking Through a Possible Bump in the Capital Gains Tax Rate

March 23, 2017

In our view, Canada may pay an unnecessary price for being out of step with President Trump’s stated tax policy approach. Though the policy details remain murky, it’s clear that the U.S. is moving toward a world of less regulation, sharply lower taxes and greater protectionism – whether we like it or not. As we move towards a Federal Budget, the talk of a bump in the capital gains tax rate is increasing.

The good news is that a significant amount of Canadian equity investments is held in tax-deferred accounts such as Registered Retirement Savings Plans (RRSPs) and pension plans. The bad news is that if the capital gains tax rate were increased, this would be the third move by the current government that is antithetical to the interests of most individual investors in Canada.

Rising tax rates for high-income earners

The first was the increase in tax rates for high-income earners; the second was the reduction in Tax Free Savings Account (TFSA) limits from $10,000 (2015) to $5,500 (2016), a level scheduled to be maintained for 2017. This trend goes sharply against that emerging south of the border. While Canada would be unwise to match every policy move the U.S. makes, there will be a price to pay if we find ourselves completely out of sync with our neighbour and main trading partner.

The risk of getting clobbered

“We have to maintain an eye to that competitiveness relationship, or we risk getting clobbered,” said John Manley, a former Liberal Finance Minister who now heads the Business Council of Canada, which speaks for 150 of the largest companies in the country. “You can diverge a little bit, but you can’t diverge a lot.”

This divergence is making the Canadian business community increasingly wary. As Barrie McKenna recently reported (The Globe and Mail, March 3, 2017: “Doing nothing risks exacerbating the chronic competitive disadvantages that Canadian businesses already face and making the country a less attractive place to invest.”

Tax rates on dividend and capital gains

The increase in tax rates for high-income earners in the 2016 budget actually had a very distortive effect on the comparable tax rates on dividend and capital gains. Specifically, the effect of the ‘dividend gross-up’ was that individuals were paying up to 1,300 basis points more tax on dividends than on capital gains.

Because corporations already pay tax on their earnings, there has always been an acceptance that capital gains (that largely result from retained earnings) should be taxed at a lower rate than ordinary income. The structure that produces this in Canada is a sub-100% inclusion rate of the gain in taxable income.

Highest tax rates on capital gains of Organization for Economic Co-operation and Development (OECD) nations?

This policy started in 1972 with increases of the inclusion rate to 75%, before the then Minister of Finance, Jean Chretien, recognized the negative ramifications of high-inclusion and reduced the rate to its current 50% level. Were the Federal Government to bump the rate of capital gains inclusion materially, Canadian individuals would have some of the highest tax rates on capital gains of the OECD nations.

It is worth saying that high taxation on investment returns, whether on dividends or capital gains, increases the cost of capital for Canadian businesses. In an environment where our neighbour to the south is likely to be lowering tax rates (and deregulating extensively), we believe that such a move is inappropriate and, potentially, self-defeating.

For further insight and analysis about this issue, please contact us:
The Wooding Group, 780 498-5047