Canadian capital gains inclusion rates uncertain following Trudeau’s resignation

Executive summary:

In January, Justin Trudeau announced his resignation as Liberal Party leader and prime minister. A prorogation of Parliament was also announced, preventing pending legislation from going into effect. This raises significant question as to the status of proposed increases to the CGIR, which now may need to be reintroduced once Parliament reconvenes before it can become law. 

On Jan. 6, 2025, Justin Trudeau announced his resignation as Liberal Party leader and prime minister once a successor to the Liberal Party is chosen. This comes less than five weeks after Canada’s previous cabinet shake-up, when former Canadian finance minister Chrystia Freeland resigned alongside the announcement of the 2024 Fall Economic Statement. Chrystia Freeland, who is now in the race to replace Justin Trudeau as prime minister, has stated she would not support raising the capital gains inclusion rate.

In conjunction with this announcement, a prorogation of Parliament was announced until March 24, which prevents pending legislation from going into effect. This raises significant question as to the status of draft tax legislation, including the proposed increases to the capital gains inclusion rate (CGIR), which now may need to be reintroduced and subsequently debated once Parliament reconvenes before it can become law.

Despite the prorogation of Parliament, the Canada Revenue Agency (CRA) has announced its intention to proceed with administering the proposed CGIR legislation using the effective date of June 25, 2024. These changes were first announced with the 2024 Federal Budget and are the first change to Canada’s CGIR since 2000.

Under current Canadian tax law, capital gains are included in taxable income at a rate of 50%, regardless of the type of property or duration the property is held. Proposed legislation would increase the inclusion rate to 66.7%, effective June 25, 2024. However, the first $250,000 of capital gains in a given taxation year earned by individuals and certain trusts would be exempt from the rate increase. Additionally, capital loss carryforwards would be adjusted to account for the relevant CGIR based on when the loss arose.

Taxable Canadian property

The changes to the CGIR may impact US multinational entities (US MNEs) that have a taxable presence in Canada (e.g., a permanent establishment) or otherwise dispose of certain assets located in Canada. 

Sales of capital property by non-residents of Canada are generally not subject to income taxation in Canada, except for a subset of capital property known as taxable Canadian property (“TCP”). In general, TCP is comprised of real or immovable property (e.g., real estate) as well as certain shares, interests and options that derive their value from real or immovable property.

For example, assume a US resident owns shares of a Canadian real estate holding company that are worth $5 million. If the US resident decides to sell the shares, the shares would likely be considered TCP and would be subject to Canadian withholding tax based on the value of the property (unless a section 116 certificate is filed to apply withholding based on the amount of capital gain recognized).

The withholding tax rate on dispositions of TCP is also proposed to increase from 25% to 35% for dispositions occurring on or after January 1, 2025. Note, however, that a taxpayer generally may file a Canadian tax return based on the amount of gain recognized and request a refund for any excess taxes withheld.

Foreign affiliates of Canadian companies

The proposed GGIR increase may also apply to gains recognized by a Canadian controlled US subsidiary under the foreign accrual property income (“FAPI”) rules, which are similar to the US controlled foreign corporation (“CFC”) rules. Where a Canadian corporation owns a sufficient ownership percentage (directly or indirectly) in a subsidiary resident outside Canada, special tax rules can apply, similar to Subpart F taxation in the United States, which attribute passive income earned by non-Canadian affiliates to its Canadian parent. These FAPI calculations can include capital gains, thus subjecting certain capital gains earned by a Canadian controlled US corporation to the CGIR in Canada.

For example, assume a Canadian parent company wholly owns a US subsidiary which in turn holds shares of public companies that are now worth $5 million and were originally acquired for $2 million. If the US subsidiary decides to dispose of the public company shares after the CGIR increase goes into effect, the US corporation would have a capital gain of $3 million of which $2 million ($3 million x 66.7%) may be subject to the capital gains tax in Canada. This taxable capital gain would be included in the taxable income of the Canadian parent company due to the FAPI rules.

If the US subsidiary subsequently repatriated those earnings to the Canadian parent company, the distribution may not be tax-free for Canadian tax purposes, depending on the ability to credit US taxes imposed on that gain and the availability of certain elections in Canada.

In addition to FAPI implications, the increase to the CGIR impacts a US affiliate’s surplus balance, which determine various tax consequences when amounts are repatriated back to Canada. Very generally, the Canadian tax treatment of dividends from a foreign affiliate is based on the surplus account from which the dividend is paid. Certain capital gains and losses relating to dispositions of shares of a foreign affiliate or partnership interest are added to the balance of a “hybrid surplus” account. Prior to June 25, 2024, a Canadian corporation received a 50% deduction on dividends paid out of the hybrid surplus account. Any outstanding balance in the hybrid surplus account will be grandfathered into a new “legacy hybrid surplus” account to retain the 50% deduction. The deduction for dividends paid out of hybrid surplus account will be reduced to 33.3% for dividends paid after the effective date under a new “successor hybrid surplus” account. For instance, if a Canadian corporation receives a hybrid surplus dividend from its US affiliate, the amount of the deduction (50% vs. 33.3%) available to the Canadian corporation in computing its taxable income will turn on whether such dividend originates from the legacy hybrid surplus or the successor hybrid surplus account.

Key Takeaways

Taxpayers should consider the impact of changes to Canada’s capital gains tax and employ an appropriate tracking methodology to allocate gains realized before or after the effective date of these changes.

Although there remains some uncertainty regarding whether these proposed changes will enter into force, taxpayers should consider filing Canadian tax returns using the higher CGIR based on current CRA guidance until contrary notice is provided. Additionally, given the prorogation and possible delays in releasing updated forms to accommodate the new CGIR, interest and penalty relief may be provided for corporations and trusts that have a filing due date on or before March 3, 2025.