To Sell or Not to Sell

To sell, or not to sell, that is the question:

Whether 'tis nobler in the planning to suffer

the prepayment of tax and shrink one's personal fortune,

or to defer those taxes and await the potential of future troubles.

I apologize in advance to those who feel I have tarnished the great words of the immortal bard. However, I do think it captures the dilemma many face with respect to the decision "to sell or not to sell" assets with capital gains before the government-imposed deadline of June 25th. After this date, the tax levied on most capital gains will rise by 1/3rd for corporations and by 1/3rd for individuals on their gains in excess of $250,000 per year.

Is the government's move a generous offer, providing an attractive window to intentionally trigger taxes? Or is it a cynical strategy aimed at accelerating taxes on assets that might have been deferred for many years? Methinks the latter.

The main purpose of this newsletter is to offer advice on the following questions:

• What are the key criteria one should consider with respect to triggering or deferring taxable gains on assets?
• How will this higher tax impact my after-tax returns for personal and corporate non-registered investments?
• What difference does portfolio design make with respect to the amount of tax one pays on passive assets?
• What planning options exist to mitigate the tax over both the short and long term?
• Will the government achieve the outcomes expressed by Jean-Baptiste Colbert, Comptroller-General of Finances under Louis XIV.

Let’s start with the first question and use a relatively simple example to show why there is no right answer. Each case is unique, and the specific circumstances and planning involved will greatly influence the outcomes and determine the optimal strategy.

The Case of Ellen and Bob

Personally Held Assets

Ellen and Bob have built a strong portfolio of assets and will be in good shape to retire well within five years. Part of their portfolio consists of individual stocks and equity mutual funds worth $1M with a cost base of $500,000 in a joint account. If they were sold today, they would trigger a $500,000 gain, and the taxable amount at a 50% inclusion rate would be $250,000, and at a 2/3rds inclusion rate, $333,334. Should they sell and pay the tax now at the lower inclusion rate or hold on and defer the tax and risk paying higher taxes in the future?

This seems like a relatively simple math exercise; however, it is anything but that. Why is this decision so complex? Because there are multiple possible outcomes. Here are a few examples. If they sell now and assuming they own the shares personally, they could pay as much as $250,000 taxable income multiplied by the maximum tax rate of 53.5% in BC. The tax would be about $133,375.

However, if we also assume they own a holding company and a business through which they receive salaries and dividends, they could also consider these steps:

1. Stop all salary and dividend income (practically speaking, this would be done in 2025 because they have already received some income in 2024).
2. On January 1st, 2025, sell half of the assets to the company and trigger $500,000 in gains ($250,000 each).
3. Pay personal taxes 16 months later on the taxable gains at graduated tax rates. In this scenario, considering the graduated rates and the $250,000 individual threshold for the inclusion rate, each of them would pay slightly more than $30,000, totalling $60,000.

This is less than half the tax with a forced sale by June 25th, and assuming the sale takes place in January 2025 also means that the tax will be due one year later. They can use some of the proceeds from the sale to pay for lifestyle expenses for that year.

Having said all that, they could, of course, choose not to sell their assets at all and defer the decision for years to come. This way, they could maintain all their capital invested in the markets, aiming to achieve a return on those investments that will outweigh the additional tax costs deferred into the future.

What other factors come into play?

• How would they feel if they sold before June 25, 2024, and the equity markets crashed (as they regularly do)? They could end up paying taxes on hundreds of thousands of gains that are no longer there. If their timing is good, they can buy back in at a lower price, assuming they had not immediately reinvested their capital. The same can be said for assets like real estate or private company shares.
• If their portfolio has low turnover, then realized capital gains each year might be quite modest (see more below in regards to turnover). As such, they would likely fall under their $250,000 personal limit and therefore be taxed with the same 50% inclusion rate they have now, meaning that additional planning would be unwarranted. However, this may not be applicable for large investment portfolios due to the scale of investment involved.
• If they are philanthropic, or with more advanced planning intend to be philanthropic with their holding company, they could donate sufficient shares to effectively eliminate any tax on the sale of the shares each year. Additionally, if they had a donor-advised fund or created one (such as the ones our clients can use through our Nicola Wealth Private Giving Foundation), they could disperse these funds to various charities over several years.

Corporately Held Assets

The planning scenario outlined above applies to individuals with a specific fact pattern. If a couple had a much larger gain and portfolio, the steps and timing would be different, but one could still achieve similar outcomes. In addition, planning for those who are single or own most of their investment assets in a holding company is different, and we’ll look at that now.

The new capital gains tax changes are more draconian for corporations than for individuals. After June 25th, all capital gains earned in corporations will be subject to a 2/3rd inclusion rate from the very first dollar. In addition, corporations do not have graduated tax rates, and private companies in British Columbia pay tax at a rate of 50.67% from dollar one of taxable passive income. That rate is mitigated to some degree by a refundable tax mechanism where 30.67% of the taxable income is credited to a refundable tax account called NERDTOH (Non-Eligible Refundable Dividend Tax on Hand), which is then refunded to the company when dividends are paid to the shareholders.

This account can be extremely helpful in long-term estate and retirement planning for most individuals or couples who own the majority of their investment portfolio in a holding company. We’ll present some examples below. But first, let’s examine the “sell or not to sell” dilemma for corporate portfolios. In this case, let’s assume Bob and Ellen have the same portfolio as above ($1,000,000 of assets with a cost base of $500,000) but it is in their holding company. The argument to sell now looks more compelling because they can get a 50% inclusion rate before June 25th, 2024, but after that, all of their gains would be subject to a 2/3rds inclusion rate.

If they sell now, their corporate tax bill would be just under $127,000, of which just under $77,000 would be credited to their NERDTOH account as refundable taxes in the future.

If they wait and sell any time after June 25th, 2024, that tax will increase by 1/3rd to about $168,900. Based on this alone, it certainly appears to make the case for triggering gains now. However, as noted above, if Bob and Ellen are long-term patient investors, they will be better off deferring triggering their gains if they can earn a return of 7% after tax for six years. If they are market timers or day traders, they are better off triggering gains now (although investors like that are very unlikely to have a $500,000 unrealized gain on a $1M portfolio).

Other considerations for dealing with this situation include:

• The holding company is subject to a tax rate of 50.67% on all taxable income. There are special rates of 27% for business income and 38.33% for eligible dividends (dividends received from other private or public Canadian companies). However, taxable income differs from total return. For instance, if Bob and Ellen earn a 7% return on a balanced portfolio totalling $3 million in a given year, that would amount to $210,000. Yet, if the portfolio is well-designed (details provided below), only as little as 40% of that might be taxable in any given year. Let’s assume that this year, $100,000 is taxable. This results in a corporate tax of $50,670, of which $30,670 is refundable. Thus, the effective tax rate is approximately 24%. Since much of the taxable income in a properly balanced portfolio consists of unrealized gains, the new 2/3rd inclusion rate is unlikely to have a significant impact on this (a detailed example is provided below).

The $30,670 of refundable taxes paid can serve as a credit against capital gains tax otherwise payable at death or can be utilized in a tax-effective manner as part of early retirement income. Let’s examine how this works.

First, we’ll make some assumptions…

Bob and Ellen are age 64 and have decided to retire full-time. They have more than sufficient savings to meet their retirement income needs between their RRSPs, IPPs, Corporate investments, and CPP. Their company has passive investments of $5 million and refundable taxes in its NERDTOH account of $1 million and its ERDTOH account (mainly created by eligible dividends from other Canadian companies) of $300,000. With the help of their advisors, they have determined that it would be best for them to try and recover these refundable taxes by age 71.

At the same time, they would defer taking any pension or RRIF income until after 71. This means they would take dividends only from their holding company for seven years. Their company will get back these refundable taxes at a rate of $0.3833 for every dollar of dividend paid out. That means over seven years, $3,391,000 of eligible and non-eligible dividends would need to be paid out or $484,000 per year (specifically $111,700 of eligible dividends and $372,300 of ineligible dividends).

The highest marginal tax rate for eligible dividends is 36.4% in BC, and for ineligible dividends, it is 48.8%. However, Bob and Ellen will benefit from the use of their graduated tax rates so their tax bill will be far smaller. Each year they will both receive $242,000 in dividends of which $55,600 will be eligible and $186,400 will be ineligible. Their tax bill will be about $64,000 and should drop slightly each year depending on inflation levels. That works out to a tax rate of 26.6% or far less than the maximum rate. Over seven years, they should pay about $900,000. At the same time, their company will receive tax refunds of $1,300,000. Over these seven years, they recover their refundable taxes very efficiently. This is a major reason for those who own companies with refundable tax credits to not try and recover those credits when they are paying personal taxes at the highest marginal rates. It is better to wait until they can control how they receive their income (early retirement, for example).

Refundable taxes as part of estate planning

While this is a more complex strategy, Bob and Ellen can arrange for their executors to take a series of steps to recover all of their refundable taxes upon the death of the last of them. Without detailing these steps here, this type of planning could reduce their overall estate tax liabilities by as much as $950,000. This is one reason why both ERDTOH and NERDTOH are also considered pre-paid death taxes. Another reason is to avoid early recovery of refundable taxes.

Portfolio design for tax efficiency

One of the best ways to reduce the impact of higher taxes on investment returns is to have a better-designed portfolio. There are several ways to accomplish this, and we list some of them below, along with a copy of a report we have created for our clients to allow them to see the difference between what they have earned and what they have to pay tax on. Here are some of the investment factors that impact the taxation of corporate and personal portfolios:

• Return of capital. This is typically realized when one owns income-producing real estate that generates rental income. Investors are allowed to use depreciation to reduce/defer taxes on that rental income, and it is then treated as a return of capital and is not taxed. This is a tax deferral but might not be realized for many years into the future.
• Eligible Dividends. These are dividends received from Canadian companies. Individuals and companies receiving these dividends pay reduced levels of tax (a maximum of 36.4% personally and 38.3% corporately). All of the corporate tax due is credited to the ERDTOH account of the company.
• Business Income. While this would be taxed at normal marginal rates for an individual, it attracts a flat rate of 27% (vs. 50.67%) when earned inside a company.
• Realized Capital Gains. These have been taxed with a 50% inclusion rate up until now. However, even going forward with an assumption of a 66.7% inclusion rate, the highest personal rate in BC on capital gains will be 35.7% (vs. 53.5%) and 33.8% corporately (vs. 50.67%). In addition, about 60% of the corporate tax will be credited to a refundable tax account.
• Deferred Capital Gains. These are returns earned on assets that are not taxable because the gain has not been realized. The time value of deferred gains can be very large if assets are held for a long time. This is the value of a low turnover/Buy and Hold approach to investing.

Below is a summary of this type of portfolio design showing both returns and tax results for one of our clients for the five years from 2019-2023. It also shows a Philanthropic model that dramatically reduces the effective tax rate of the portfolio. This specific portfolio is corporate, so refundable taxes and capital dividend accounts are factors.

What can we observe from this report?

• The total return of 51.1% net of all costs is equivalent to an 8.6% annual rate of return.
• While the total return over five years was just over $2.7 million, only about $850,000 of that was taxable.
• The tax paid of almost $430,000 was an effective tax rate of about 15.9% over the five years. Of that, more than $250,000 was credited to a combination of NERDTOH and ERDTOH.
• The capital dividend account credit of just over $285,000 will save this taxpayer just over $100,000 in future personal income taxes.
• Total realized gains over five years are about 20% of the total return earned. That means that 80% of the returns would not have been impacted by any increase in the capital gains inclusion rate. We recalculated these numbers assuming that the inclusion rate was 66.7% for the last five years. It has the impact of increasing the effective tax rate from 15.9% to 17.7% over the five years.
• One can reduce overall taxes significantly by utilizing a philanthropic strategy. A corporation is allowed a maximum donation to a charity, foundation, or donor-advised fund of 75% of taxable income. In this case, that would amount to $636,000 over five years. Bob and Ellen had already committed 20% of their estate to philanthropy, and by using this approach, they can save a lot of tax much earlier and then experience the benefits of their gifts while they are alive. By the numbers, it looks like this:

1. 5-year earnings of $2.7 million.
2. $636,000 added to their donor-advised fund.
3. Net corporate tax payable is about $107,000.
4. Funds available for reinvestment are $1,957,000.
5. Effective tax rate just under 4%.
6. 96% of all returns either reinvested or in their donor-advised fund.
7. We can improve these results even more if part of the portfolio is in the form of publicly traded shares or funds as per the example below.

Let’s consider a scenario within this portfolio where there are U.S. and Canadian equity funds with an Adjusted Cost Base (ACB) of $250,000 and a market value of $500,000. This implies that upon sale, the capital gain would amount to $250,000, of which $166,750 would be taxable, resulting in a tax liability of just under $84,900.

However, if these funds were contributed as a donation to a charity, donor-advised fund, or foundation, the taxable capital gain would be reduced to zero. Additionally, there would be an additional tax savings of just over $250,000 realized from the gift itself (calculated as $500,000 x 50.67%). Furthermore, this transaction would generate a capital dividend credit of $250,000. Consequently, shareholders could withdraw $250,000 in tax-free dividends, reducing personal taxes by as much as $122,000. In total, corporate and personal tax savings could amount to as much as $457,900, representing more than 90% of the actual gift.

It's important to note that the examples provided are specific to the given fact pattern. Readers should consult their financial and tax advisors to determine which approaches would be most effective for their individual situations. Regardless, even without the philanthropic strategy, these results are highly favourable.

Despite the effectiveness of the planning outlined above, there are several areas where the impact of the higher inclusion rate will be significant. These areas include:

• Capital gains on the sale of non-primary residences.
• Liquidity events such as the sale of a business or farm.
• Taxation of estates because of the deemed realization of capital gains triggered at death.

We will look at the issues and options for all three of these situations in an upcoming webcast scheduled to be completed over the next few weeks. While there may be instances where it makes sense to trigger gains now and pre-pay taxes, for most individuals, superior options exist through careful planning and deferral strategies.

The analysis above demonstrates that deferring taxes rather than prepaying them tends to be advantageous in many, if not most, cases. It also highlights that future capital gains taxes may occasionally be higher at the corporate level compared to the personal level. Importantly, 60% of corporate taxes can be recovered, whereas no such recovery exists for personal taxes paid.

For the majority of our clients, corporate investing, coupled with sound planning and portfolio design, emerges as the optimal choice. Keep an eye out for our upcoming follow-up newsletter, where we'll further explore this topic using a case study approach.