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Canada’s Capital Gains Tax Changes Sparks Economic Debate

Taxes and Innovation | April 19, 2024

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In the 2024 federal budget, Canada proposed significant changes to the capital gains tax, specifically increasing the inclusion rate to 2/3 for gains exceeding CAD 250,000. This policy shift is poised to have profound implications that have sparked a country wide debate.  The 2024 Canadian federal budget proposed several changes to capital gains taxes that could both support and challenge entrepreneurs, innovators, investors, and Canada's competitiveness and productivity.

Capital Gains Tax Changes in the 2024 Budget

  • Increase in Capital Gains Inclusion Rate: The budget increases the capital gains inclusion rate from 1/2 to 2/3 for dispositions after June 24, 2024. For individual taxpayers, this increase applies to the portion of capital gains realized in excess of an annual $250,000 threshold. This could potentially deter investment by increasing the tax burden on larger gains, which might impact investor behavior negatively by reducing the after-tax return on investments.

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  • At the same time, conversely, the budget introduces a new Canadian Entrepreneurs’ Incentive, which offers a reduced inclusion rate of 1/3 for up to $2 million of certain capital gains realized by entrepreneurs on the sale of small business corporation shares, provided certain conditions are met. This could encourage long-term investment in small businesses and reward entrepreneurs who are deeply involved in their businesses for extended periods.

Two Investor Examples

Let’s develop detailed case examples for two types of investors—domestic and foreign—looking into the impact of Canada's 2024 budget changes on capital gains taxes. These examples will help investors evaluate how the new tax regulations could affect their investment strategies in the Canadian market.

Case 1: Domestic Investor in a High-Tech Startup

Jordan, a Canadian resident, invests in a high-tech startup focusing on AI technology. Jordan invests CAD 500,000 and after five years, the investment appreciates to CAD 3 million, resulting in a capital gain of CAD 2.5 million.

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Current Tax Regime

  • Inclusion Rate: 1/2
  • Taxable Gain: 1/2 × CAD 2.5 million = CAD 1.25 million
  • Assumed Tax Rate: 50%
  • Tax Owed: CAD 1.25 million × 50% = CAD 625,000

New Tax Regime with Increased Capital Gains Inclusion Rate

  • Inclusion Rate for Gains > CAD 250,000: 2/3
  • Reduced Rate for First CAD 250,000: 1/2
  • Taxable Gain on First CAD 250,000: 1/2 × CAD 250,000 = CAD 125,000
  • Taxable Gain on Remaining CAD 2.25 million: 2/3 × CAD 2.25 million = CAD 1.5 million
  • Total Taxable Gain: CAD 1.625 million
  • Tax Owed: CAD 1.625 million × 50% = CAD 812,500

Jordan pays significantly more under the new regime. This could deter high-volume domestic investors from aggressive investment strategies due to a higher tax burden on larger gains.

Case 2: Foreign Investor in Canadian Real Estate

Sophia, a U.S. investor, buys into Canadian real estate focusing on luxury properties. She purchases a property for CAD 2 million, which appreciates to CAD 3.5 million over five years, realizing a gain of CAD 1.5 million.

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Current Tax Regime

  • Inclusion Rate: 1/2
  • Taxable Gain: 1/2 × CAD 1.5 million = CAD 750,000
  • Assumed Tax Rate for Non-Residents: 25% (simplified for example purposes)
  • Tax Owed: CAD 750,000 × 25% = CAD 187,500

New Tax Regime with Increased Capital Gains Inclusion Rate

  • Inclusion Rate: 2/3
  • Taxable Gain: 2/3 × CAD 1.5 million = CAD 1 million
  • Tax Owed: CAD 1 million × 25% = CAD 250,000

Sophia also faces a higher tax expense under the new regime. This increase might discourage foreign investment in sectors like real estate, traditionally attractive due to favorable capital gains tax rates.

Increase in Capital Gains Tax Could Reduce Attractiveness of Canada as an Investment Destination

The increase in the capital gains tax could potentially reduce the attractiveness of Canada as an investment destination, particularly for large-scale investments expecting significant capital gains. For both domestic and foreign investors, the increased tax liability diminishes the net returns, making it crucial to reassess whether the investment still aligns with their financial goals and risk tolerance.

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Investors might need to look for alternative investment opportunities within Canada that could potentially offer tax incentives or consider diversifying to other markets with more favorable tax treatments. This reevaluation will help in making informed decisions that align with their strategic investment objectives.

Considerations for Supporting the Tax Change

  • The increased tax revenues generated from the higher inclusion rate could be reinvested into public services, infrastructure, or debt reduction, which are essential for maintaining and enhancing the country’s economic stability and quality of life.
  • Simultaneously, by introducing incentives like the Canadian Entrepreneurs’ Incentive, the changes encourage investments that are not only profitable but also sustainable and beneficial to the economy in the long run, such as small businesses that create jobs and innovate.
  • Equity and Fairness: Increasing the tax burden on larger gains primarily affects higher-income earners, which could be seen as a move towards a more equitable tax system where those with greater financial means contribute more.

Some economists support the changeMichael Smart, a tax policy expert and economics professor at the University of Toronto:

This government is taking action because they need money badly, given the deficit situation. We should understand that.  But credit to them for doing a hard thing to fix a real inequity in our tax system, which allows very high-income individuals to, in some cases, pay a lower rate of tax than ordinary Canadians do because they're getting their income as capital gains. We have had a system in Canada that favours capital gains, favours people holding onto assets to get gains, instead of getting dividends or selling assets to invest in a different stock or a different business venture and so on.  That's not good for productivity. We should move towards levelling the playing field so that all investors are paying a fair tax rate, given their incomes, at the same tax rate on every form of investment.”

Considerations for Opposing the Tax Change

  • Higher taxes on capital gains could deter both domestic and foreign investors, potentially slowing economic growth. This is particularly risky in a global economy where capital can move to jurisdictions with more favorable tax environments.
  • If the capital gains tax is perceived as too high, it might make Canada less attractive and less competitive, compared to other countries with lower rates. This could influence not only investment decisions but also the operations of multinational corporations and startups.
  • There’s a risk that increasing capital gains taxes could lead to capital flight, where investors move their funds to countries with lower taxes, thus reducing the available capital for Canadian ventures.

Benjamin Bergen, President of Council of Canadian Innovators - have mobilized a letter in support against the new capital gains tax changes in an Open Letter:  Prosperity for Every Generation.

”The tech industry is viewing this budget as hostile.  This shows a fundamental misunderstanding of how the innovation economy works. Ultimately, it will set our country back.”

Balancing Tax Fairness with Canada's Competitiveness

Fairness refers to the principle of equitable distribution of wealth and taxation, where those who have more are expected to contribute more to the societal pool. This concept addresses concerns about wealth inequality and the social responsibility of affluent individuals and businesses. Advocates for the increased capital gains tax argue that it ensures those who gain the most from the economy pay a fairer share of taxes. By imposing a higher tax rate on larger capital gains, which typically accrue to wealthier individuals, the policy aims to redistribute wealth more equitably and fund public services that benefit all. From an ethical standpoint, fairness in taxation can help reduce societal disparities and improve access to opportunities for lower-income groups.

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Competitiveness involves creating an economic environment attractive to investment and business operations, essential for economic growth, job creation, and innovation.  Advocates against the tax increase might argue that higher taxes on capital gains could make Canada less attractive to investors, both domestic and foreign. They contend that capital is highly mobile in today’s global economy, and investors may seek regions with lower tax burdens, potentially leading to a decline in investment and economic dynamism. Lower competitiveness can stifle economic growth, reduce job creation, and deter innovation, which are critical for long-term prosperity.

The challenge lies in finding a balance where the tax system is fair and progressive without undermining the country's ability to attract and retain investments. This balance is crucial for fostering an environment where businesses want to invest and grow, while also ensuring that the benefits of economic activities are reasonably distributed among all Canadians.

Dan Kelly, president of the Canadian Federation of Independent Business (source):

They seem to have one foot on the gas, one foot on the brake on the very same file.

Unintended Consequences

The proposed changes to the capital gains tax in Canada's 2024 budget could have several unintended consequences.

  • By increasing the capital gains tax rate, especially on larger gains, there might be a decrease in investment activity. Investors could be deterred by the prospect of lower net returns, leading to less capital being injected into the Canadian economy. This could affect sectors that heavily rely on investment for growth, such as technology and real estate.

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  • There is a risk of capital flight, where investors move their funds to countries with more favorable tax environments. This could particularly impact high-net-worth individuals and institutional investors looking to maximize their returns by allocating resources to jurisdictions with lower capital gains taxes.
  • Investors might shift their strategy from capital gains-focused investments to those that offer better tax advantages. For example, they might prefer investing in dividend-yielding stocks or real estate investment trusts (REITs), which might offer better after-tax returns under the new tax regime.
  • The higher capital gains tax could stifle the entrepreneurial spirit, as potential rewards from selling a successful startup might become less attractive. This could have long-term effects on innovation within the country, as fewer individuals might be willing to take risks associated with starting new businesses.

These unintended consequences highlight the need for careful consideration and possibly staged implementation of new tax policies to monitor impacts and adjust strategies as necessary to mitigate negative outcomes.

How Important is Innovation and Global Competitiveness to Canada?

The juxtaposition of increased taxes against incentives like the Canadian Entrepreneurs’ Incentive is the government's attempt to balance equity with economic vitality. However, the potential to discourage significant domestic and foreign investment cannot be overlooked. Investments are the lifeline of innovation, particularly in high-growth sectors like fintech and technology, which rely heavily on robust capital infusion for research, development, and scaling operations.

While the increased capital gains tax might seem like a move towards greater tax fairness, ensuring those with higher income contribute more, it is crucial to assess whether this fiscal policy might inadvertently dull the entrepreneurial spirit or curb the ambition of innovators. These are the individuals and enterprises poised to drive future growth, and their success is tightly coupled with the nation's economic health.

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On a broader scale, Canada’s position as a competitive hub for fintech innovation is at stake. Comparatively higher capital gains taxes could make Canada less appealing to international investors and fintech firms considering where to establish their operations.

One option is to implement a more nuanced structure for capital gains taxes that features graduated inclusion rates based on the size of the gain and the duration of investment. This could incentivize both short-term and long-term investments.

Decisions made today will shape Canada’s economic trajectory well into the future, making it imperative that they support a vibrant, competitive, and innovative national economy.

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