By Jon Shell
In the 24 hours after the federal budget was announced, my social media and news feeds were inundated with misinformation about the capital gains tax changes and some shockingly bold predictions about how they’ll affect the country. I haven’t seen such a strong reaction to a Budget since Bill Moreau’s failed 2017 effort, and there’s a ton of groupthink going on. A lot of the reaction is based on misunderstanding of what’s actually proposed. So, before you sell your home and move to Austin, or fire your employees, or decide to become a welder instead of acting on your terrific tech start-up idea, let’s talk about what’s in the Budget.
First, what’s been proposed is an increase in the capital gains inclusion rate, from 50% to 66.67%. This is not a tax rate. The number of people getting this wrong makes me glad we have lots of accountants in this country (for the first time). To clarify, “inclusion rate” is the percentage of capital gains (profit after deducting what you paid for the asset that you sold) included in your income for tax purposes. On eligible capital gains before this change, 50% of those gains were added to your income, and now 66.67% will be added to your income. Meaning, if you pay tax at a 50% rate (50% rate used for ease), you would have paid 25% before, and 33.33% now.
Second, the above only applies to individuals on a capital gain of more than $250K in a given year. For example, let’s say your stock options pay off, and you make a capital gain of $500K one year. The first $250K are still included in your income at 50%, so you’ll pay about $62K on that gain – same as before. The next $250K is included at the new rate, and you’ll pay just over $83K on that (instead of an additional $62K). This is an increase of about $20K more in tax on a gain of $500K. If we bump that to $1M in capital gains, you’ll pay about $62K more in tax. And also, congrats! You’ve done well.
“A lot of the reaction is based on misunderstanding of what’s actually proposed. So, before you sell your home and move to Austin, or fire your employees, or decide to become a welder instead of acting on your terrific tech start-up idea, let’s talk about what’s in the Budget.”
Third, the Lifetime Capital Gains Exemption (LCGE) has been increased, and this is a really, really big deal for a lot of entrepreneurs. Right now, the LCGE is about $1M and is being increased to $1.25M. That is an increase of $250,000 in tax-free earnings, but is actually worth a lot more for many Canadian entrepreneurs because many of them make use of multiple LCGEs by transferring shares to spouses or other family members, each of whom can use their own LCGE.
So let’s imagine a small business with two equal partners, with one spouse and one child each as shareholders. For that company, this change means that there can be an increase of $1.5M of tax-free capital (i.e. $250K times 6 people). That’s a savings of about $375K of tax savings compared to the old inclusion rate of 50%. If these business owners sell their company for a gain of anything up to $7.5M, the proceeds will be entirely tax free. That is a huge win for the vast majority of Canadian entrepreneurs.
Fourth, one of the main arguments against the change is that it will discourage people from founding new companies. As someone who’s started four companies and had hundreds of conversations with founders over the years, I can tell you that no one thinks about the capital gains tax rate when they’re bitten by the entrepreneurial bug. Duncan Rowland wrote a great post on LinkedIn on the topic. The actual impact on proceeds for founders depends on a lot of things, but as the Canadian Entrepreneurial Incentive kicks in the “break-even” will be between $5-10M. If a founder exits for a gain of $5M or less, they pay less in tax with these changes, while a gain above $10M results in more. This spreadsheet lays it all out, but on the whole it’s hard to see this changing the motivation of entrepreneurs.
Finally, the inclusion rate for capital gains tax was 75% in the 1990s, which also happens to be the decade many of those currently worried about our “productivity crisis” say was best for productivity, growth, investment, etc. The inclusion rate was lowered to 50% in 2000, around when we started to see lower productivity, so it’s certainly not clear that capital gains tax rates had much direct impact on Canadian productivity. What we know for certain, though, is that cutting the inclusion rate was great for the super rich, and was certainly great for me when I sold my companies in 2020.
In fact, as Trevor Tombe points out, increased rates should discourage share buy-backs by Canada’s public companies, which should lead to more business investment. Business investment is generally considered the most important driver of productivity. My point is that anyone who says, with certainty, that the increase in the capital gains inclusion rate will lead to lower productivity in Canada is making a claim they can’t back up with facts.
There are legitimate areas for debate about these measures. But as this discussion unfolds, it’s critical to understand what they actually mean, and for those in the debate to present the changes fairly and honestly. And, as is always the case, beware of anyone who seems certain about the long-term economic impact of these changes, as they’d be the first person in history blessed with that level of insight.
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