The 2016 Federal Budget

Last Tuesday, the Minister of Finance, Bill Morneau, delivered the Liberal governments much anticipated 2016 Federal budget.

While much of the budget had been floated and/or proposed during the election and confirmed in part on December 7th (the middle-class tax cut and 4% increase in tax rates for high income earners) by Mr. Morneau, there were some still some surprises.

In January, I wrote a blog post on how the "Top 1%, are not Happy Campers". I would suggest they are still not (see my CBC National News interview on this topic here and the story of this high earner leaving Canada). Yet, I think between all the trial balloons and rumours, from raising the small business tax rate to 26.5%, to a possible increase in the capital gains rate from 50% to 75%, many of the "Top 1%" felt they escaped tax Armageddon to some extent. However, if you are a small business owner or professional, there were many under the radar changes that may significantly impact your future tax planning and depending upon your fact situation, potentially result in even more income taxes. If planned, it was an excellent job of misdirection from the government in respect of high income earners.

The "middle-class"are the winners here. However, I still want to reserve judgment as to how big a win certain people had. The "middle-class" has lost the family tax cut worth $2,000 to some people. In addition, much of the "middle-class" gain revolves around children, so if you are single or do not have children or only say one child, your benefit is not quite as large. Finally, the new Canada Child Benefit ("CCB") starts to phase out on adjusted family income in excess of $30,000, so many families will have a reduction in their child tax benefit. So while most people will be net winners, some middle-class people may not benefit as much as they anticipate. This Toronto Star article
presents some interesting numbers on how the federal budget affects everyday Canadian families.

Business Changes

The budget contains several proposals that will close down many popular tax planning techniques used by high income earners. These include:

a) The transfer of personal life insurance policies to private corporations that allow the shareholder to extract tax-free funds. New measures will reduce or eliminate these transfers effective March 22, 2016. For those who transferred policies prior to the budget date and took back tax-free shareholder loans, essentially the new proposal will cause the tax-free capital dividend received by the corporation upon your death, to be reduced by the tax-free loans you took from your company while alive. 

b) Many partnerships created structures whereby the partners had corporations that provided services to the partnership allowing them to potentially access the $500,000 small business exemption. For taxation years that begin after March 21, 2016, the budget will change the rules to catch this type of service income. I am surprised it took this long to eliminate this type of planning.

c) It is somewhat common for the spouse of a high income earner to incorporate a company that provides services to their spouse's corporation. This planning can often allow both spouses corporations to access the $500k small business deduction. Also applicable on or after March 22, 2016, the budget will deem the service income to not be eligible for the SBD where the shareholders or a person does not deal at arm's length (such as spouses). Thus, combined, the two related corporations can only claim $500k SBD in total.

Other Business Changes

1. The small business tax rate reductions legislated by the Conservative government will be frozen at 10.5% for 2016 and beyond.


2. The Eligible Capital Property regime (such as goodwill, customer lists and licences) will now be replaced with a new capital cost allowance class (Class 14.1) with a 5% declining balance. The CEC balances will be transferred effective January 1, 2017. This is very complex, but will be less beneficial than the current regime in many cases as active income is now being turned into investment/property income.


3. There will be significant changes to transfer pricing and anti-surplus stripping and various foreign transactions which are beyond the scope of this post (meaning, way too complicated for me and you need a non-resident specialist).

Miscellaneous Personal Changes

1. The budget proposes the elimination of the children's fitness tax credit, arts tax credit and education and textbook tax credits as of January 1, 2017. The children's fitness tax credit and arts tax credit will be halved for 2016 and you can continue to carry forward unused education and textbooks credits. The Federal tuition credit is unchanged.

2. The family tax cut will be eliminated for 2016 and subsequent years.

3. The child tax benefit and universal child benefit will be combined into one non-taxable Canada Child Benefit ("CCB"). The CCB will provide annual benefits of up to $6,400 per child under six years old and up to $5,400 per child six through seventeen. On the portion of adjusted family net income between $30,000 and $65,000, the benefit will be phased out at a rate of 7 per cent for a one-child family, 13.5 per cent for a two child family, 19 per cent for a three-child family and 23 per cent for larger families. Where adjusted family net income exceeds $65,000, remaining benefits will be phased out at rates of 3.2 per cent for a one-child family, 5.7 per cent for a two-child family, 8 per cent for a three-child family and 9.5 per cent for larger families, on the portion of income above $65,000.

The budget proposes to provide an additional amount of up to $2,730 per child eligible for the disability tax credit.

4. The retirement age for Old Age Security will be rolled back to age 65.

5. Many mutual funds have been structured to allow "switches" among the funds (known as corporate class funds) to avoid triggering tax. The budget proposes that for dispositions after September 2016, a taxable disposition will occur when you switch among mutual funds with the exception of switches between series of shares within a class (i.e.: the shares within the class are essentially the same funds).

6. There was no budget proposals in respect of stock options, a pleasant surprise, given the Liberals had discussed restrictions being implemented.

7. The Conservative governments proposal to allow the donation of real estate or private corporation shares will not proceed.

The budget contained multiple proposals, but I have only touched on a few. For many of the proposals, the devil will be in the details.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

Stocks with Capital Gains- To Give unto Ceasar or not

I have always been confounded by people who are reluctant to sell a stock that has increased in value because they have to pay capital gains tax. It goes without saying, that income taxes can have a significant impact upon your portfolio’s value over time. Obviously, the longer you can avoid paying income tax, the greater capital you will have at work. However, some people are so adverse to paying income tax on their stock gains, that they are paralyzed from making a sound investment decision.

The underlying question that I will try and address in this blog is: how much a factor should the income tax on your capital gain be when selling shares, if you cannot find a viable replacement equity? I suggest it should be a non-factor.

It should be noted that this blog will revolve around the sale of individual stocks, not mutual funds; as some corporate class funds can be utilized to defer capital gains. I have also not considered an equity monetization strategy based on the assumption that for most readers, monetization is not practical, as I have only seen it used one or twice in all my years practice.

While writing this blog, I came across an interesting statement in Sacha Peter’s Divestor Blog (a favourite on my blog roll) that was right on topic. In his blog “Links and after-tax calculations,” Sacha states that he finds it personally very frustrating to hold onto investments that have appreciated beyond what he considers to be its fair value, but he is "prevented" from selling these stocks because of the capital gains taxes that he would incur.

I commented on Sacha’s blog that I did not really understand his comment. I stated that "Capital gains tax in Canada is 23% or less and to me, that is not an onerous rate. Yes, one never wants to pay tax, but I see people hold onto stocks because they don’t want to pay the tax on stocks that have appreciated past their fair value and the stock sharply corrects. To me, 23% or less is not a large detriment to take a profit when you compare it to the 46% you pay on interest and employment income and compare it to the potential true cash loss you may incur by holding a stock that should be sold.”

Sacha’s response to my comment was “I agree with you from a practical perspective. Academically I outlined a scenario in my previous post that illustrates the situation.” Sacha then provided the  example below which follows the conventional wisdom in regard to selling stocks. This conventional wisdom is succinctly expressed by Greg Forsythe of the US security firm Schwab; "Sell an existing holding if another stock compatible with your risk tolerance is available that provides higher return potential after subtracting any taxes and transaction costs in executing the swap".

Sacha says “Let’s take a hypothetical investment between two securities. Security ABC is a perpetual bond, paying $10 per unit. Security DEF is a perpetual bond of the same issuer, with substantively the same seniority/call provisions as ABC, paying $8 per unit. Your marginal rate (to make the math easy) is 50%.

Let’s pretend you bought ABC for $80, netting a pre-tax yield of 12.5% and after-tax yield of 6.25%. If ABC is now trading at $100/share, what price does DEF have to be in order for the decision to be a net positive? Assume frictionless trading costs, and capital gains taxes are payable immediately upon disposal. For this to be a break-even transaction, your $95 ($100-$5 tax) in after-tax dollars must equal the income of the prior portfolio, mainly $10. $10/$95 = 10.53%, so you must buy DEF below $76/unit in order for your transaction to make financial sense."

Sacha continues "I will again completely agree that this academic exercise is of little use in the grey and fuzzy world of investing in that you never quite know whether you got fair value correct and whether the geniuses on the other side of the computer screen think their idea of fair value is higher or lower.”

Just to be absolutely clear, I am not picking on Sacha. I asked him if I could use his response in this blog, I am just using his response for discussion and illustration purposes. In the above response, Sacha compares two securities based on coupon rate and unrealized gains. His example requires comparable alternatives and is not necessarily his analysis for the sale of a single stand alone stock.

Now, I am not the academic or mathematician that Sacha is, but I guess my issue with conventional wisdom is should one not consider the valuation of a stock and the net proceeds that will be achieved after-tax instead of always looking for a break even alternative or stock with a potentially higher return (i.e.: an alternative may not always be available when you wish to sell a stock and thus, should the income taxes then not become a moot point?).

To illustrate, if I bought Nortel at $50 and sold it at $100, since I thought $100 was fair value, I would have had approximately $88 in my pocket after-tax. Now, look at the many Canadians who held onto Nortel as it rose in price. As I recall, many people were concerned Nortel was way overvalued, but they did not sell their shares because they did not want to pay the large income tax bill associated with their gains. Following with the above example, when Nortel was $130, you could have sold and realized approximately $112 after-tax. At $115 you would have realized $100 after-tax and, as noted above, at $100 you would have realized approximately $88 after-tax.

However, many Canadians held on and did not sell until the $60 range or less. At $60 you would have realized approximately $57 after-tax. Your net after-tax loss of not selling at a pre-determined fair value of $100 was $30 or more, even after paying the income tax.

It is my suggestion that once you feel a stock has hit full value, place a stop-loss order at that pre-determined value and look past the paralyzing income tax decision to your after-tax proceeds and return. Deal with what you will do with those funds as a standalone question.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.