Capital gains change aids investors

There is no doubt that Finance Minister Paul Martin could have done more for long-suffering Canadian taxpayers. The relief he offered in his recent mini-budget amounted to less than a third of the anticipated federal surplus over the next year.

That said, it would be churlish not to acknowledge that progress has been made on a number of important fronts.
· Raising to $100,000 the threshold at which the top marginal tax rate applies is certainly a major step.  It’s also a break with the long Liberal tradition that that anyone earning more than $60,000 a year was somehow “rich”.

· Reducing the capital gains inclusion rate to 50 per cent was another significant move. However, it should be noted that all Mr. Martin did here was to restore the situation that existed before the Conservative government of Brian Mulroney brought in the $100,000 capital gains exemption. At that time, the inclusion rate was raised to 75 per cent on gains that exceeded the exemption, on the acceptable grounds that people who had already earned $100,000 in tax-free profits should pay a little more once they got beyond that level.

But when Mr. Martin abolished the exemption ihis first budget, he left the inclusion rate at 75 per cent, where it has been until this year. That created the paradoxical situation of low-risk dividends being taxed at a rate below that of higher-risk capital gains. That made no sense, but finally some fiscal sanity has been restored.

How to profit
The reduction of the inclusion rate has a number of important implications. There are several ways you can profit from it.

· The obvious one is selling a stock or mutual fund for more than you paid for it.

· The new rule makes royalty income trusts with large tax-deferred distributions more attractive. These include the oil and gas trusts, some of which are making 100 per cent tax-deferred payments (Canadian Oil Sands Trust is an example).

A tax-deferred distribution is exactly what it sounds like. You pay no tax on the money in the year it is received. However, the cost base of your units is adjusted for capital gains purposes. Let’s say you invest in a royalty trust and pay $20 a unit. Over time, you receive $8 in tax-deferred payments. Your adjusted cost base (ACB) will be $12 ($20 – $8). When you sell, the ACB is used to determine capital gains liability.

With the inclusion rate down to 50 per cent, this reduces the negative effect of this process. Let’s use that $8 in tax-deferred distributions as an example. You haven’t paid tax on any of that money. Now you decide to sell for $25 a share. Your actual capital gain is $5 a unit but for tax purposes it is $13 ($25 less your ACB of $12). But at a 50 per cent inclusion rate, you actually pay tax on only $6.50 per unit. If your marginal rate is 48 per cent, that works out to $3.12 per unit.

Over the period you owned the shares you made a total of $13 in profits (distributions plus capital gain). So your effective tax rate works out to 24 per cent. That’s half your normal marginal rate. Under the system as it was before this year’s twin budgets, the effective rate would have been 36 per cent. So the tax relief is considerable.

· Another way to take advantage of this change is to contribute shares to an RRSP. Any capital gain at the time the stock goes into the plan is taxable, but the burden will be reduced by the lower inclusion rate.

· The reduced rate will also be an important factor in estate planning, because all capital gains are deemed to be realized in the year of death and taxed accordingly, unless the assets are passing to a spouse.

There are many other ways in which the reduced tax burden on capital gains can be used effectively. It’s just a matter of using some imagination.

Adapted from the Internet Wealth Builder, published by Gordon Pape. For membership information: