Navigating Canada’s New Capital Gains Transition Rules: A Comparison of the Department of Finance’s June and August Draft Legislation

By Amit Ummat and Alisha Butani

In the Federal Budget released on April 16, 2024, the Government of Canada proposed increasing the capital gains inclusion rate. For corporations and trusts, the rate was proposed to increase from 50% to 66.67%. And similarly, for individuals, the rate on capital gains realized in a year exceeding $250,000.00 was proposed to increase from 50% to 66.67%. On June 10, 2024, the Department of Finance released draft legislation (“June Proposal”) to implement these changes commencing on and after June 25, 2024. The June Proposal was subject to criticism from tax practitioners, particularly regarding Canadian Controlled Private Corporations (“CCPCs”) potentially being subject to inequitable tax treatment when it realized capital gains, depending on its year end. In response to the public feedback, the Department of Finance revised the June Proposal, releasing an updated version on August 12, 2024 (“August Proposal”). The June Proposal and August Proposals (collectively, “Proposals”) are largely similar, however, there are notable nuanced amendments and additions in the August Proposal. This article aims to compare the transitional year rules provided in the Proposals.

At the outset of this Article, providing a brief definition of Capital Dividend Account (“CDA”) is essential. CDA is part of a mechanism designed to achieve integration by generally allowing the untaxed portion of capital gains to flow through CCPCs without being subject to an additional layer of tax. If a CCPC has a CDA balance at the end of a tax year, it may choose to distribute this surplus to its shareholders as tax-free capital dividends.

The June Proposal contained transitional rules to specify how taxpayers that have a net capital gain/loss in the period from the beginning of the year to June 24, 2024 (“First Period”) and a net capital gain/loss in the period from June 25, 2024, to the end of the year (“Second Period”) are to determine the capital gain inclusion rate. The formula proposed was: (1/2 × A + 2/3 × B) ÷ (A + B), where A is the net capital gain/loss of the taxpayer from dispositions in the First Period, and where B is the net capital gain/loss of the taxpayer from dispositions in the Second Period (“Formula”). The result of the Formula is that a taxpayer is subjected to a blended rate of the capital gain inclusion rates of 50% and 66.67%, based on the proportion of net gains/losses realized in the First Period and Second Period.

The single blended inclusion rate faced criticism from tax practitioners because it causes problems with determining a CCPC’s CDA balance at a specific point-in-time. Accurate evaluation of a CDA’s balance at a specific point in time is crucial to ensure that a CCPC has sufficient non-taxable gains to cover the capital dividends it intends to pay its shareholders. The single blended inclusion rate prevents a point in time calculation for CCPC’s CDA balance at any point in time during the transition year, as it instead requires CCPC’s capital gain/loss in the transition year to be calculated only at or after the year end. This is problematic because it can result in CCPCs having a lower-than-expected CDA balance when it distributes capital dividends to its shareholders, thereby potentially resulting in tax under Part III of the Act if the dividends paid exceed the CDA balance immediately before the time of payment. However, if this situation were to arise, it may be avoided if the shareholders receiving the dividend and the CCPC make an election under subsection 184(3) of the Act to treat the excess as a separate taxable dividend.

In response to the above issue pointed out by the public, the Department of Finance released the August Proposal which contained amendments and additions to the June Proposal. The August Proposal eliminated the single blended inclusion rate and replaced it with a new subsection 89(1.4) of the Act, which contained a special rule about how a corporation should determine their CDA balance at any time in respect of its taxation year that commences prior to June 25, 2024, and ends after June 24, 2024 (“transition year”). Under the new paragraph 89(1.4)(a) of the Act, calculating a Corporation’s CDA balance during the transition year requires deeming a corporation’s taxable capital gain/allowable capital loss from the disposition of property in that year to be subject to a different inclusion rate depending on if the disposition occurred prior to June 25, 2024, or on or after June 25, 2024. Indeed, dispositions occurring prior to June 25, 2024, are subject to a 50% inclusion rate, whereas dispositions occurring on or after June 25, 2024, are subject to a 66.67% inclusion rate. Paragraph 89(1.4)(a) of the Act, unlike the Formula contained in the June Proposal enables corporations to determine their CDA balance at any point in time during the transition year, thereby mitigating the risk of attracting Part III tax under the Act.

The August Proposal also contains new paragraphs 89(1.4)(b) and 89(1.4)(c) of the Act. These paragraphs explain that if there is a difference between the inclusion rate determined by paragraph 89(1.4)(a) of the Act and that determined pursuant to section 38 of the Act at the end of the transition year, then when a corporation is calculating its CDA balance their capital gain/loss will be deemed to adjust for the difference.

In conclusion, the Department of Finance invited public comments on the August Legislation concerning changes to the capital gains inclusion rate until early September 2024. It will be noteworthy to see what feedback the public made, if any, and how the Department of Finance will respond to that feedback.