Capital gains taxation – Deferred, preferred and more

Four ways to give a tax assist to your investment returns

As an investor you may hold stocks and bonds directly, or you may hold them inside a mutual fund. Either way, your investment objectives will be a combination of principal protection, income generation and capital growth.

Your priorities among these objectives will vary over time depending on your other income sources, your current and future spending needs, and your emotional comfort level with the performance of the securities market.

Acknowledging the importance of principal protection, the key distinction for tax purposes is between income and capital. Income off investments includes things such as interest and dividends that are tax annually as earned and paid. Capital on the other hand is essentially the principal that is invested, with many favourable aspects applying to its taxation.[1]

Of syrup & hardwood, income & capital

While not a perfect analogy, income is like the sap that flows from a maple tree. The annual harvest is converted to syrup, while the remaining nutrients allow the tree to continue to grow. At such time as the owners decide they’d rather have a hardwood floor than a sugary treat, the tree can be cut down. Similarly, regular income is annually taxable, but capital is allowed to appreciate until harvested.

It is the growth in the capital that is taxed, not the entire capital. The starting point for the calculation is the adjusted cost base (ACB) of the investment. Most often the ACB is simply your acquisition cost, but there may be some adjustments, for example it is increased by purchase costs, such as commissions.

The capital gain (or capital loss – more on that below) is the difference between the fair market value (FMV) as proceeds of disposition, and the ACB. Generally, the proceeds of disposition will be the sale price less any commissions and other selling costs. However, if the proceeds are less than FMV, for example if the investment is given as a gift, the investor/giver’s capital gain will still be FMV minus ACB.

How do the tax rules work in favour of capital gains?

Focusing then on capital, there are a number of ways that our tax system treats capital gains favourably.

1. Deferral until disposition

In order for there to be a capital gain (or loss), there must be an actual or deemed disposition of property. An actual disposition would be an intentional sale of a stock on an exchange, or a redemption of units from a mutual fund provider. Deemed dispositions are imposed by law (that’s what is meant by “deemed”) in situations like a direct transfer to another person, or when the investor becomes a non-resident or dies.

Until there is a disposition, the capital may grow in value year after year without being taxed. Comparatively, most investment income (such as interest, royalty payments and dividends), is taxed annually when it is received. In some situations, the amount will be deemed to be received, such as when interest is credited to an investment rather than paid directly to the investor, or when dividends are automatically reinvested in a stock or a mutual fund. In either situation, the investor will have to use other money to pay the tax on the income, and in the case of dividend reinvestment, this increases the investor’s ACB.

2. Preferred treatment, with only partial income inclusion

As noted, a capital gain is equal to FMV minus ACB, but only a portion of that is taxable. The “taxable capital gain” is derived by applying the income inclusion rate to that capital gain. The inclusion rate has varied over the decades:

- Capital gains were tax-free prior to the major overhaul of the income tax system in 1971.
- Beginning in 1972, 1/2 of capital gains were taxable.
- In 1988, the inclusion rate was raised to 2/3, along with a $100,000 lifetime capital gains exemption (LCGE).
- In 1990, the rate was increased to 3/4, and by 1994 the LCGE was restricted to farm and fishery property, and small business corporation shares. As of 2024, the LCGE is $1.25M, with indexing resuming in 2026.
- Early in 2000 the rate was dropped to 2/3, and then later that year it was brought back down to 1/2.

Now, in accordance with the 2024 Budget, the inclusion rate has again risen to 2/3, but the 1/2 rate remains available for individuals on the first $250,000 of capital gains in any year. For trusts and corporations, the 2/3 rate applies to all capital gains. The 1/2 rate is used in the examples for the balance of this article, on the assumption that the investor is an individual with less than $250,000 of annual capital gains.

3. Proportional imposition of tax on disposition

If an investor does not sell the entire investment, the capital gain will be proportional to that disposition. This can result in a current tax effect that is less than the investor’s actual tax rate at the time. The best way to illustrate this is through an example: An investor who has a constant marginal tax bracket rate of 40% puts $1,000 into a mutual fund that grows to $1,500 over five years when she withdraws $150.

- $100 is a non-taxable return of capital, calculated by multiplying the withdrawal times the ACB divided by the FMV: $150 x [$1,000/$1,500] = $100. (The ACB is reduced to $900 for future calculations.)
- The capital gain is the difference: $150 – $100 = $50. At 1/2 inclusion, the taxable capital gain is $25.
- At a 40% bracket rate, the tax on the taxable capital gain is $25 x 40% = $10.

In sum, the net after-tax cash from the $150 withdrawal is $140, which is an effective tax rate of 6.7%. Tax is not disappearing; it is just being deferred until later dispositions.

4. Capital gains distributed from a mutual fund

When a mutual fund rebalances its holdings, it may realize capital gains. As a high tax rate entity, it will commonly distribute such capital gains to instead be taxed to its investors. Fortunately, those distributed gains retain their character, and so are taxed to the investor as capital gains, with the investor’s inclusion rate determining the size of the taxable capital gain.

Note that a mutual fund may be legally structured as a trust or corporation. In a corporate structure there are multiple funds within it that must net their gains and losses, sometimes resulting in lower capital gains distributions compared to trust-structured mutual funds. While this may affect the expected amount of distributions in a given year, the character of such distributions remains capital gains.

The other side of the coin – Capital losses

If an investor disposes of capital property for less than its ACB, there will be a capital loss instead of a capital gain. When a capital loss is realized in a year, it is applied to reduce any capital gains in that year. If the capital losses exceed the capital gains in the current year, the investor can choose to carry back any remaining losses to offset capital gains in any of the three immediately preceding tax years. In doing so, the investor re-files the income tax return for the relevant year(s) to obtain a refund of taxes previously paid.

Another option is to carry the capital loss forward to be used against future capital gains. There is no limit to the time that capital losses may be carried forward.

Transfers between spouses

Capital property may generally be transferred to a spouse at its ACB, both during lifetime and upon death. This also applies to transfers to a trust where the spouse is the capital beneficiary. In the case of investments that have appreciated, as long as there is no disposition there will be a continued deferral of capital gains realization.

Even though transfer is at ACB, later realized capital gains (and future income) is usually attributed to the original spouse, though some of this effect may be limited with informed planning, so obtain tax advice.

[1] This discussion is about non-registered investments; there is no relevant tax distinction between income and capital gains in registered accounts like RRSPs, RRIFs and TFSAs.

A tax strategy about nothing

What Seinfeld can teach us about the value of staying the course

Like a lot of families, we’ve been doing things differently while social distancing during the pandemic. In addition to dusting off board games and semi-regular family walks, our latest streaming service has allowed us to catch up on classic TV, including Seinfeld.

More than three decades since it hit the air, there’s still something about the sitcom that came to be known as the show about nothing. That worked in the world of comedy, and may give us something to think about in the more serious world of portfolios.

I’m certainly not suggesting that investors set up portfolios once and ignore them thereafter. On the contrary, it’s imperative to be aware of economic developments — such as the market movements since the onset of Covid-19 — as well as any changes to the businesses behind individual securities.

Financial advisors are the source for this kind of information, reviewing with clients what’s relevant (including the effect on the investor’s appetite for risk) and deciding if adjustments are warranted. Those may include portfolio changes, behavioural changes, or both — or nothing at all.

The critical point is to resist the urge to make changes for the sake of change alone. The urge to just do something can be particularly harmful to a non-registered portfolio.

Unlike registered accounts, changes to non-registered holdings can result in taxable dispositions. Tax deferral that an investor enjoyed while holding rising securities over the course of years will be realized when those securities are sold.

If those portfolio changes are based on a focused review, then the tax implications should not stand in the way of action. However, if the original portfolio continues to suit the investor’s planning needs, then a premature change not only drifts away from the plan but also compounds that diversion by triggering taxes unnecessarily.

A tale of two investors: Gerry & Jorgé

Consider sister and brother investors Gerry and Jorgé, 40 year-old fraternal twins saving for an elaborate trip together for their 50^th birthdays. Both have high incomes, so we’ll use a 50% marginal tax rate. Ten years ago, each used $10,000 to buy 1,000 units of VanDelayed mutual fund for $10 per unit. The price rose as high as $18, but has since come back to $14. It pays no dividends.

Despite the recent price decline, Gerry leaves her investment alone. Jorgé, on the other hand, is convinced that VanDelayed will continue to fall, so he sells.

With a fair market value of $14,000 and a $10,000 adjusted cost base, Jorgé realizes a $4,000 capital gain. As half the capital gain is taxable, he has a $2,000 taxable capital gain that costs $1,000 in tax, leaving him with $13,000.

A few months later Jorgé reconsiders and decides that Gerry was right. As it turns out, the price is again $14 when he reinvests his $13,000.

Ten years later when it’s time to book the trip, VanDelayed is at $28.

Gerry’s $28,000 holding realizes a $18,000 capital gain, resulting in $4,500 in tax, netting to $23,500.

With the price doubling from $14 to $28 from the time Jorgé reinvested, his $13,000 rose to $26,000. Taking away $3,250 tax due to the $13,000 capital gain, Jorgé is left with $22,750.

Even though Jorgé got back in at the same price as when he exited, the early tax payment hampered his growth, putting him $750 behind Gerry. The amount lost would vary depending on the growth rates, but, as long as there was indeed growth, the difference would never come out to nothing — which is something to think about.

Transferring capital losses between spouses

Advantageous use of the superficial loss rules

Our tax system is based on each individual as a distinct taxpayer as opposed to taxing a pooled unit such as a couple or a family.

Even so, there is a built-in acknowledgement of these personal relationships in many ways; for example, the ability to transfer capital property between spouses at adjusted cost base (ACB). This defers recognition of any existing unrealized capital gains and associated taxes until there is a disposition by the recipient spouse.

But sometimes it may be preferable not to have that ACB rollover apply. One such occasion is when one spouse has capital losses and the other has capital gains. By strategically managing the superficial loss rules, the couple can transfer the loss so that it can be used by the spouse with the gain.

Superficial loss rules

A taxpayer’s capital losses in a year must first be applied against that year’s capital gains, with any remaining net capital loss allowed to be carried back up to three years or forward indefinitely. Where identical property is involved, the timing of those gains and losses is critical.

The superficial loss rules deem a capital loss to be nil if an individual purchases identical property 30 days before or after the disposition (a 61-day window) and still holds the property on the 31st day after the disposition. Concurrently, the ACB of the acquired property is increased by the amount of the denied loss, preserving the ability to claim the loss in future.

The rules also apply if certain related parties carry out a purchase, such as a trust of which that taxpayer is a major beneficiary, a controlled corporation or – perhaps most commonly and central for the purposes of this strategy – a spouse.

By strategically managing the series of transactions, the tax results can be split among taxpayers, enabling a couple to use the rules to transfer a capital loss between them.

Steps to transfer the loss

The strategy is most easily explained through an example. Let’s assume Eve has 300 XYZ Ltd. shares in in her non-registered account with an ACB of $30,000 and a fair market value (FMV) of $20,000. Her spouse Adam already has a realized capital gain of $10,000 this year. To maintain focus on the transfer of the capital loss, we’ll assume no market movements.

Step 1 – Eve sells her 300 XYZ shares on the exchange on day 0.

Step 2 – Within 30 days before or after Eve’s sale, Adam purchases 300 XYZ shares on the exchange.

Step 3 – No earlier than the 31st day after Eve’s sale, Adam sells his XYZ shares on the exchange.

As Adam’s purchase is within the 61-day window, Eve’s $10,000 loss is deemed to be nil. Adam would have spent $20,000 to acquire the XYZ shares, to which is added the $10,000 denied loss, giving him an ACB of $30,000. When Adam sells, he will incur a $10,000 capital loss.

For this to work, Adam must use his own funds for the purchase, or he could obtain (and service) a prescribed-rate spousal loan from Eve if the funds are in her hands. As well, bear in mind that if this is part of a broader series of transactions, the Canada Revenue Agency may seek to invoke the general anti-avoidance rule, or “GAAR.”

It is also possible to transfer the capital loss by transferring property between the spouses directly, for example, shares of a closely held corporation. In that case, the spouses must take the further step to elect out of the automatic ACB rollover that would otherwise apply. A detailed example of this procedure is included in our InfoPage titled “Capital loss planning.”

Mutual funds – Form matters

If the property in question is a mutual fund, remember that investment mandates are often available in trust and corporate forms. The two forms are not treated as identical property under the superficial loss rules.

This could work to a taxpayer’s benefit in trying to reduce his/her own capital gains. Let’s say that a mutual fund trust holding had lost value, but the taxpayer is confident that it is positioned well for the future. The holding could be sold and the corporate version acquired. The superficial loss rules will not apply, so the capital loss will be immediately usable by that taxpayer.

However, for the spousal capital loss transfer to succeed, the spouses actually want the superficial loss rules to apply. Hearkening back to our example, If Eve sells a mutual fund trust and Adam acquires a mutual fund corporation, Eve will have a capital loss that she has no present use for. For the capital loss to transfer, Adam must be sure to buy the same mutual fund trust as Eve held.

As a final note, be aware that a mutual fund company’s frequent trading rules could affect the timing of transactions and possibly their cost. It would be well-advised to vet the intended transactions with a tax professional to be sure that they carry out as intended.