How Investors Should Be Thinking About Capital Gains Tax Today

During uncertain times, the mindset of an investor must switch from one of wealth accumulation to wealth preservation. This switch in mindset typically calls for a reduction in a portfolio’s exposure to riskier asset classes (such as stocks) and an increase in exposure to less risky asset classes (such as cash). In times of uncertainty, cash is king. During market panics, everything tends to sell off together as investors all try to reduce their risk at the same time, the “baby gets thrown out with the bath water.” This is why cash will dominate as an asset class during sell offs. This year alone we have witnessed two major sell-offs in the market: the first taking place from February 19th – March 23rd and the second which started on Sept 2nd and is still ongoing.

After a decade’s long bull market in stocks, those investors that “de-risked” their portfolios by selling stocks are very likely ‘locking-in’ sizeable profits or what is commonly known as “capital gains.” This is both good news and bad news. The bad news is the government will come knocking, looking for its share of your recently realized profits/capital gains in the form of capital gains tax. The good news is that you don’t pay capital gains taxes unless you yourself are better off having earned a profit , that is, you have successfully made your money work for you.

In this article, we will give our readers an overview of what a capital gains tax is, how it is calculated and the potential impact on you should the capital gains tax rate increase in the near future.

Capital gains tax was first introduced in Canada in 1972. Prior to this, all capital gains were tax free. The Canadian government introduced the capital gains tax as on offset for their removal of the inheritance tax, in order to help finance the growing cost burden of social security.

A capital gain is the difference between the sale price of a security and the average cost paid to acquire that same security. For example, if you paid $10 per share to buy 100 shares of Company XYZ, this would cost you $1,000. A year later, if you sold the same 100 shares at a price of $15 per share, your total sale proceeds would be $1,500. The capital gain would be $500 ($1,500 - $1,000).

To calculate the capital gains tax owed to the government, the capital gain is multiplied by an inclusion rate (currently 50%) and the product of the two is then taxed at the investor’s marginal tax rate. Continuing with our example, the $500 capital gain would be multiplied by an inclusion rate of 50%; resulting in $250 deemed taxable. This $250 would then be taxed at a rate of 46% (assuming the highest Canadian tax bracket), leaving the investor with a tax bill of $115 (46% x $250) and an after-tax profit of $385 ($500 - $115) from the sale of their 100 shares of Company XYZ.

While the provincial and federal income tax rates are subject to change, the important variable that the government can and has changed to alter the capital gains tax owed is the inclusion rate. The below table shows how the inclusion rate has changed over the years:

The Canadian government has spent an enormous amount of money on COVID-19 mitigation in 2020 with a jaw dropping $343 billion projected deficit for this year alone. Eventually this money will have to be funded from somewhere and there is a possibility that some of it will be from an increase in the capital gains tax. Predictably when the Federal Government has a bill to pay, rather than adjust their own spending, they turn to the wealthy. We don’t expect this time to be any different. Specifically, we would expect a higher capital gains tax resulting from a return to a higher inclusion rate. Capital gains taxes historically have been an efficient means for the government to transfer wealth from the “Haves” to the “Haves Nots”. This is because it tends to be the high income earners that have the excess savings to invest in the stock market. Therefore, increasing the inclusion rate would result in higher taxes only on this wealthier segment of individuals while sparing the lower income households without savings. Unfortunately, unlike in 1972 when the capital gains tax was introduced to help cover the cost of social security, this time around an increase in the capital gains tax would go towards covering the unlimited amount of spending the government has embarked on, under the pretext of dealing with a pandemic.

If there is a chance that the government of Canada is likely to increase the inclusion rate, this raises an important decision for investors today. Specifically, would an investor be better off selling their portfolio today and buying it right back in order to trigger capital gains tax at the current inclusion rate of 50%, or holding off on selling today and risk having to pay a higher capital gains tax in the future? To assist in thinking through this dilemma, consider the following illustration which assumes a doubling of the inclusion rate from 50% to 100%:

In both scenarios, we’ve assumed that the original cost of each portfolio is $5.00 and that the market value of the portfolio has increased 50% to $7.50 today through historical gains in the portfolio.

Scenario One: In fear of future higher capital gains tax, the investor decides to sell his entire portfolio at the current market value. The capital gains are taxed at the lower current capital gains tax rate today. The after-tax proceeds are then reinvested, forming the new cost base for future capital gains calculations, and the portfolio proceeds to compound at an expected rate of return for either five or ten years at which point the portfolio is sold and the capital gains are taxed at the higher tax rate.

Scenario Two: the investor holds onto his portfolio with no sale and thus the market value of his portfolio compounds at the [same] expected rate of return for both five and ten years at which point the portfolio is sold and is taxed at the higher capital gains tax rate.

The above table uses a 2.5% annual rate of return. As highlighted in blue, you will conclude that the investor would be better off selling the entire portfolio today to trigger capital gains tax at the lower tax rate (Scenario One) than they would be if they did not sell their portfolio until a later date at a higher tax rate (Scenario Two).

However, the Summerhill Team performed multiple scenario analysis using different annual rate of returns and discovered that:

1) For all annual portfolio returns between 2.5% and 20% per year on a five year time horizon, the investor was better off selling their portfolio before the tax increase.

2) For all annual portfolio returns up to 10% per year on a ten year time horizon, the investor was better off selling before the tax increase.

3) For all annual portfolio returns between 10% and 12% per year on a ten year time horizon, the investor would be indifferent between selling before the tax increase and waiting.

4) For all annual portfolio returns greater than 12.0% per year on a ten year time horizon, the investor was better off NOT selling before the tax increase.

Conclusion: Unless the investor believes they can produce portfolio returns greater than 10% each year for a decade, they would be better off selling before the increase in taxation and buying back the portfolio.

One of the golden rules of investing and accumulating wealth over the long-haul is delaying paying taxes for as long as possible. Doing so allows the investor to continue to earn a return on the amount that will eventually have to be paid to the government. In essence, this amount can be thought of as a negative interest bearing loan from the government, in that the government is paying you an amount equivalent to your annual return for holding the amount eventually owed to them. Additionally, because the investor ultimately decides when to trigger the capital gains tax by opting to sell their securities, the investor decides when the ‘government’s loan’ will get called. This is why the “buy and hold” investment strategy tends to result in far superior returns than an active trader with high portfolio turnover. The active trader is continuously faced with repetitive tax bills that eat away at their investable capital base.

However, as we’ve illustrated in the aforementioned example, this golden rule may have a unique one-time exception if there is a threat that the capital gains tax rate could rise in the future and that future investment returns are to be more muted going forward. Based on elevated valuations today, future returns could very well be much lower than in the past.

The government of Canada will be faced with multiple tough decisions when the party finally ends and the bills come due in announcing exactly how it plans to deal with their reckless spending. Unfortunately, since fiscal prudence is never followed during the boom years, when we find ourselves in a recession, the government lacks the financial cushion to manage us through this uncertain time. Generally any shred of fiscal discipline is thrown out the window to accommodate the political pressure from idealists. There are never any adults in the room any more. Raising the capital gains inclusion rate will have negative consequences and unfortunately will severely penalize the retirement savings of the Baby Boomers after decades of accumulating a nest egg to retire. Of note is that we are unlikely to see any of the inflation indexed government pensions impacted in any way. It is well publicized that many Baby Boomers already lack the financial savings to sustain their living standards through retirement and a higher tax burden will not help this. This is why investors need to consider all potential tax consequences on their portfolio today and should consult their tax accountants as to the most optimal strategy in order to minimize their taxes.

The Summerhill Team