In our previous CH Minute, we looked at volatility and changing investment prices. This week, we look at what happens after your investments have increased in value and it is time to sell: how capital gains arise, how they’re taxed, and why they are taxed the way they are.
How do capital gains arise?
A capital gain is an increase in the value of an investment such as a stock, property, mutual fund, or other asset that you own in a non-registered account (outside of an RRSP, LIRA, or TFSA).
When you still own the asset, any capital gain that you may have is considered “unrealized”. That is, the gain is still hypothetical until you sell the asset and realize the gain. In Canada, capital gains are taxable only when the gain is realized: when the asset is sold and you have either received your proceeds or those proceeds are due to you.
The main thing that differentiates capital gains from other income sources like employment income, dividends, interest, and business sales is that capital gains are only partially taxable. Whereas you need to pay tax on 100% of your income receipts, you only need to pay tax on 50% of your capital gain. For example, if you buy a stock or share for $100 and then sell it five years later for $400, then your capital gain is $300 ($400 – $100) and the taxable portion of that gain is $150 ($300 x 50%).
The history of capital gains taxes
Capital gains have not always been treated the same way by the Canadian government. In fact, it’s only in the last 20 years that gains have been treated as they are now.
Before 1972, capital gains were not taxed; in this year, a tax on 50% of capital gains was introduced to increase fairness in our tax system and help fund social security. In 1988, the inclusion rate (the percentage of the gain that is taxable) was increased to 66.67%. In 1990, this was increased again to 75%.
In early 2000, the inclusion rate was lowered back down to 66.67%, and then it was lowered again to 50% in later 2000. It has remained unchanged at this level ever since.
The future of capital gains taxes and their impact on investors
Many Canadians have unrealized capital gains built up in their investment holdings and part of our long-term planning for our clients involves preparing for the inevitable taxes that will result when these investments are sold. This planning is straightforward when we assume that the current tax treatment and tax rates will persist. However, if our history tells us anything, it’s that we can’t rely on tax policies staying the same forever.
You may have heard talks in the news recently that the capital gain inclusion rate could increase back up to 75%. On the one hand, we can say that rumors of increases have floated around for years without rates changing. But what would happen if the government raises the inclusion rate back up to 75%? That could mean future payment of thousands or tens of thousands of dollars in extra income taxes. That is something we would all like to avoid, or, at the very least, we’d like to be able to plan for this in advance to be ready for the cash needs.
Using our previous capital gains example of a stock bought for $100 and sold later for $400 the gain of $300 would potentially have to pay tax on $225 of income instead of $150. The total tax bill could be up to 50% higher.
Capital Gains and Mutual Funds
Before wrapping up there is one other important point to keep in mind. Mutual funds as a rule are structured in such a way as to maximize capital gains since this remains the most tax efficient way to earn income in Canada. This benefits fund owners in two ways. First, it makes tax planning much simpler. When an investor holds a bunch of individual securities, decisions need to be made on when and where to realize gains and losses, how to offset interest and foreign income (which is very tax inefficient), and otherwise manage tax liabilities as they arise. Mutual funds do this automatically as a part of their mandate.
Secondly, most, if not all of the capital gains earned within the fund stay in the fund and are not triggered until the client elects to do so. This means income can be transferred from high tax years into lower tax years in the future (such as after retirement). The potential tax savings, especially when coupled with the benefits of staying invested for the long term, and maximizing the time value of money make this type of investing even more attractive.
This is why at CH Financial, we don’t just manage your investments. We also consider your tax needs and future planning. In the case of capital gains and the future taxes that may be owed, we consider the use of tax-protected investment vehicles, as well as other strategies to monitor your accounts to look to minimize your tax liabilities.
This edition of the CH Minute we discussed the benefits of investing in mutual funds due to their tax efficiency benefits. Not only do they have the ability to defer capital gains years into the future but they also don’t have the liquidity issues that individual equities typically do. We at CH strongly believe in our ability to offer competitive returns though our mutual fund products as well as efficient tax saving benefits. This puts our clients at an advantage by being in this type of investment. As always, we encourage conversation and if you have further questions, please do not hesitate to reach out to us.
As always, we welcome any questions or comments.
All the best,
Stephanie Murray, Chief Financial Officer
& Your CH Financial Team