Before 1972 there was no tax on capital gains in Canada. In that year, as part of a major overhaul of the tax scheme, capital gains taxes were imposed. The inclusion rate for capital gains (the percentage subject to tax) has varied over the years from the present level of 50% to as high as 100%, with stops (both in the year 2000) at 75% and 66% along the way. There is currently much speculation that the federal government will increase the inclusion rate in order to help finance the enormous budget deficit being rung up due to the COVID-19 crisis. Some accountants we know have urged their clients to realize existing capital gains now, before the rates go up. Is that a smart idea?

It turns out that, as with most things involving taxes, it is complicated. Much depends on how much (if at all) the inclusion rate will go up, whether you want to hold the stocks you might sell for a long time, how high the dividend is on the stock, and how well or poorly the stock market will do in the future. In order to assist in decision making, here is a numerical example.

You bought 100 shares of Apple at (split adjusted) $20/share, and they are now at $120. Congratulations! If you sell today you have a capital gain of $10,000, and you would pay (top bracket) $2,500 in taxes. Since you still want to own the stock, you reinvest the after-tax proceeds and you now have only 79 shares. Let’s assume that the capital gains inclusion rate does go up to 100% (major bummer), and that you sell the shares in 10 years at $240/share – good for you, they doubled! Did you make a good decision by paying taxes early?

The person who didn’t sell still has 100 shares, now worth $24,000, but with a capital gain of $22,000. At full inclusion that means a tax hit of $11,000 and net proceeds of $13,000.

You have only 79 shares, now worth $18,960, but your cost base is much higher, $9,480, so you only have a capital gain of $9,480 and a tax hit of $4,740. You have net proceeds of $14,220.  Hey, look at that! It worked! You came out ahead by $1,220!

But wait, what about dividends? Apple currently pays about $0.82 per year, with a dividend growth rate of 9% per year. Over ten years that would amount to total dividends of about $12.46 per share. If you still own 100 shares, you would get $1,246, but if you took the early capital  gains hit you only have 79 shares and your dividends would be only $984 or $262 less. That eats into your advantage, bringing it down to $958. On a $24,000 sale, that is a win of about 4% over 10 years, or 0.4% per year.

Here are four important things to note:

  • If you plan to sell shares within a year or two, taking the capital gains hit at the lower inclusion rate will be a winning idea even if the rate only goes up to 75%.
  • If you plan to hold for ten years as in this example, the strategy is only a winner if the inclusion rate doubles from 50% to 100%. At a lower inclusion rate you lose more by having fewer shares than you gain by paying less in taxes.
  • If you own a stock with a high dividend, say 4% instead of the less than 1% used in this example, the longer you own the stock, the more you give up by paying taxes early. In the example above, if Apple payed a dividend of 4% the loss of dividend income would be more than the capital gains tax savings and the strategy would be a losing idea.
  • The strategy works best for low dividend stocks that don’t go up much in value. If Apple goes to $300 in ten years (growth of 9.5%/year), the strategy only breaks even at the highest inclusion rate of 100%.

Our conclusion is that except for very short term investors, paying capital gains taxes early will not save much money, regardless of what the government does, and could easily be a losing strategy. Even in the worst case of an increase to 100% inclusion, over a period of years the higher rate will not make a huge difference. For many stocks, particularly high yield names like banks, utilities and telephone companies, the income foregone as a result of paying taxes early may well be greater than the tax savings.

Nobody likes paying taxes and the idea of tax rates increasing quite rightly should make investors consider their strategy. As good carpenters say, measure twice, cut once. In this case we think the analysis is clear, and that doing nothing is the better course of action.