TaxMatters@EY – December 2024

Alan Roth, Toronto

In last month’s edition of TaxMatters@EY, we included Part 1 of “Asking better year-end tax planning questions,” which looked at the questions, topics and tax planning techniques that may apply to you each year. In Part 2, we focus on the questions and topics that are specific to the 2024 taxation year and recent personal tax changes.

Specifically, in Part 2 we look at the proposed increase to the capital gains inclusion rate, the impact of that increase on employee stock option deductions, increases to the lifetime capital gains exemption, measures denying deductions for noncompliant short-term rentals, new rules for intergenerational business transfers, business transfers to employee ownership trusts, and the broadening of the base for the alternative minimum tax. We also discuss the proposed new Canadian entrepreneurs’ incentive, effective in 2025.

Addressing these points can help you with the forward-looking planning process described in Part 1.

Have you considered the impact of any changes to personal tax rules that are effective in 2024?

Increase in capital gains inclusion rate: The 2024 federal budget and corresponding draft legislation introduced an increase in the capital gains inclusion rate (the proportion of realized net capital gains that is included in calculating your income for tax purposes) from one-half to two-thirds, effective for dispositions of property occurring on or after June 25, 2024. Individuals and certain trusts are eligible for an effective one-half inclusion rate on the first $250,000 of capital gains (net of capital losses) realized in a year.^1,2

For example: You bought shares of a public company several years ago for $500,000 and then you sell them on or after June 25, 2024 for proceeds of $1,500,000, thereby realizing a capital gain of $1,000,000 on the sale. You have no other realized capital gains or losses for the year.

Under the proposed rules, $125,000 of the first $250,000 of that gain (one-half) is taxable and $500,000 (two-thirds) of the remaining $750,000 is taxable for a total taxable capital gain of $625,000.³ The taxable capital gain is then taxed at personal marginal income tax rates. Previously, only $500,000 of the total realized capital gain would have been taxable, when the entire capital gain would have been subject to a one-half inclusion rate.

Several technical and consequential rules have also been proposed, as well as various transitional rules that apply for the 2024 taxation year.

If you’re planning to sell investments or other capital assets and your total realized net capital gains would exceed the $250,000 threshold, consider (if possible) selling some of those assets before the end of 2024 and the remainder in 2025 to benefit from the $250,000 threshold in each of those years. Note that if the assets are jointly held by you and your spouse or common law partner, you may each use your respective $250,000 thresholds.⁴

Impact of capital gains inclusion rate increase on employee stock option deductions: If you have acquired shares under an employee stock option plan, the excess of the value of the shares on the date you acquired them over the price you paid for them is included in your income from employment as a stock option benefit. The benefit is generally included in your income in the year you acquire the shares. But if you have acquired Canadian-controlled private corporation (CCPC) shares under an employee stock option, the benefit is normally taxed in the year you dispose of or exchange the shares, rather than in the year you acquired them.

Until recently, one-half of employee stock option benefits included in income generally qualified for a deduction, provided certain conditions were met. This resulted in stock options that met the necessary conditions effectively being taxed at the same rate as capital gains, when capital gains were subject to a one-half inclusion rate.

To reflect the proposed increase in the capital gains inclusion rate (see above), draft legislative amendments reduce the employee stock option deduction to one-third of the stock option benefit for stock options exercised after June 24, 2024. In the case of CCPC stock option benefits, the stock option deduction is reduced to one-third where the acquired share is disposed of or exchanged after June 24, 2024. This is the case even if the CCPC stock option was exercised before June 25, 2024, when the one-half stock option deduction was in effect.

However, you may be able to claim an increased deduction equal of one-half of the stock option benefit up to a combined annual limit of $250,000 for both employee stock options and capital gains. The annual $250,000 threshold applies only in respect of net capital gains realized and stock options exercised (or where the acquired share is disposed of or exchanged, in the case of CCPC options) after June 24, 2024.

If your total employee stock option benefits and realized net capital gains exceed $250,000 in a taxation year, you will be able to choose the allocation of the preferential tax treatment — that is, the lower capital gains inclusion rate and higher stock option deduction — between the capital gains and the stock option benefit.

For more information on the capital gains inclusion rate and employee stock option deduction changes, see the Feature chapter, “Recent changes to the taxation of capital gains and employee stock options”, in the latest edition of Managing Your Personal Taxes: a Canadian Perspective, TaxMatters@EY, September 2024, “Spotlight on recent changes to the taxation of capital gains and employee stock options”, TaxMatters@EY: Family Wealth Edition, October 2024, “How could the capital gains inclusion rate increase affect you?” and EY Tax Alert 2024 Issues No. 28 and 33.

Increase in lifetime capital gains exemption: Canadian individuals are entitled to a limited lifetime capital gains exemption (LCGE) from tax on net capital gains realized on the disposition of certain qualified property. The LCGE is available to shelter capital gains realized on the disposition of qualified small business corporation (QSBC) shares or qualified farm or fishing property.

The QSBC share rules are quite complex, but very generally require the shares to be shares of a CCPC that have been owned for at least two years immediately before the sale and for the corporation to meet an active business asset test at the time of the sale and throughout the two years immediately prior to the sale.

For example, at the time of the sale, 90% or more of the fair market value of the corporation’s assets must be attributable (directly or through connected corporations) to assets that are used in an active business carried on primarily in Canada.

Similarly, the rules for determining if a property is a qualified farm or fishing property are also complex. However, qualified farm or fishing property generally includes real property or a fishing vessel used in a farming or fishing business, shares of a farm or fishing corporation, an interest in a farm or fishing partnership, and certain intangible property (such as milk and egg quotas and fishing licences) used principally in a farming or fishing business, but only if certain other conditions are met.⁵

On January 1, 2024, the LCGE increased to $1,016,836 from $971,190 for QSBC shares and $1,000,000 for qualified farm or fishing property in 2023 due to the annual adjustment for inflation. However, to alleviate some of the impact of the proposed increase in the capital gains inclusion rate for small business owners, the government also proposed an increase in the LCGE limit to $1,250,000 for dispositions that occur after June 24, 2024, representing a sizeable increase compared with the 2023 limits.

As a result of the increase in the inclusion rate for capital gains realized after June 24, 2024 (see Increase in capital gains inclusion rate above) and the proposed increase in the LCGE, the effective maximum lifetime deduction that may be available to you will increase from $508,418 (i.e., $1,016,836 x 1/2) to $833,333 (i.e., $1,250,000 x 2/3). Additional deductions may be available under the proposed Canadian entrepreneurs’ incentive and the employee ownership trust rules (see below).

For more information, see the Feature chapter, “Recent changes to the taxation of capital gains and employee stock options”, in the latest edition of Managing Your Personal Taxes: a Canadian Perspective.

Non-deductible short-term rentals: Recent legislative amendments include new rules to prevent short-term rental operators from claiming an income tax deduction for expenses incurred to earn short-term rental income in any province or municipality that has prohibited short-term rentals.

For purposes of these rules, a short-term rental is defined as a residential property that is offered for rent for a period of less than 90 consecutive days.

If your short-term rental property is located in a province or municipality that permits such rentals but you fail to comply with all provincial or municipal licensing, permitting or registration requirements, you will also be unable to claim income tax deductions for your property. The new rules apply to all rental expenses incurred to earn rental income (e.g., interest, insurance, repairs, property taxes, utilities), effective for rental expenses incurred after 2023.

A residential property includes all or part of a house, condominium unit, apartment, mobile home, cottage, trailer, houseboat or other property in Canada that is permitted to be used for residential purposes under applicable law.

For 2024, a short-term rental is deemed to be compliant for these purposes if all registration, licensing and permit requirements are met on December 31, 2024. In other words, if your rental property is currently a noncompliant short-term rental because it does not comply with all applicable registration, licensing and permitting requirements, you have until the end of December to meet these requirements. In such a case, your short-term rental property will be considered compliant so that any expenses incurred to earn rental income from the property will be deductible for the entire 2024 taxation year.

For further details, see TaxMatters@EY, June 2024, “New measures to address housing supply shortage and affordability”.

Alternative minimum tax: Changes affecting the calculation of the alternative minimum tax (AMT) are effective for 2024 and later years.

The AMT is designed to ensure that individuals, including certain trusts, with high gross income, who would otherwise pay little or no income tax because they have a significant number of certain tax preference items, pay at least a minimum amount of tax for the year.⁶ Tax preferences are specific items that reduce taxable income or tax payable, such as the capital gains exemption or the tax credit for political donations.

Under the revised AMT rules, the basic exemption amount you can claim has increased from $40,000 to the amount that corresponds to the lower threshold of the fourth federal income tax bracket, which is indexed annually to inflation ($173,205 for 2024, and $177,882 for 2025). The flat federal minimum tax rate has also increased to 20.5% (from 15% under the pre-2024 rules).

Under the revised rules, you must include 100% of capital gains and current-year capital losses in your adjusted taxable income. This is increased from 80% under the pre-2024 rules. The 100% inclusion rate also applies to capital gains allocated to you from a trust as a beneficiary of that trust. If you have capital gains arising from donations to a registered charity or to another qualified donee, you must also generally include 100% of those gains in your adjusted taxable income under the revised rules. Under the pre-2024 rules, you did not need to make adjustments for capital gains on donated property when computing your adjusted taxable income for AMT purposes. The only exception to the new 100% capital gains inclusion rate is for donations of certain publicly listed securities—in that case, you only need to include 30% of the relevant capital gains in your adjusted taxable income.

In addition, under the pre-2024 rules, if you received employee stock option benefits eligible for the stock option deduction for regular tax purposes, you had to effectively include 80% of those benefits in adjusted taxable income. Under the revised rules, you must include 100% of the benefit. There is one exception. If you make a donation of optioned shares that are publicly listed securities, and the donation is made to a registered charity or other qualified donee within 30 days after the shares were acquired, you must include 30% of those benefits for AMT purposes under the revised rules. Under the pre-2024 rules, such benefits were fully exempt from AMT, the same as regular tax.

The revised rules also disallow 50% of most non-refundable tax credits that were previously fully available to reduce the AMT, including the basic personal credit and the medical expenses credit. However, only 20% of the charitable donations credit is disallowed under the revised rules. Full deductions are allowed with respect to the Guaranteed Income Supplement, social assistance and workers' compensation payments.

For more information about the AMT and the other key changes, see TaxMatters@EY: Family Wealth Edition, October 2023, “Alternative minimum tax: proposed changes you should know”, EY Tax Alert 2023 Issue No. 45, and EY Tax Alert 2024 Issue No. 25.

Intergenerational business transfers: For 2024 and later years, new rules apply to facilitate intergenerational business transfers, while safeguarding against unintended tax avoidance loopholes.

Until recently, it was significantly more advantageous for a taxpayer to sell the shares of a corporation carrying on a family business to an arm’s-length party than to a corporation owned by the taxpayer’s children or grandchildren. If the shares were sold to a corporation owned by one or more of the taxpayer’s children or grandchildren, the sellers would be deemed to have received dividends rather than realized capital gains. Dividends are subject to higher rates of personal tax than capital gains.⁷

In addition, since the sellers would not realize a capital gain for tax purposes, they would not be able to use their LCGE against capital gains realized on the disposition of QSBC shares or shares of the capital stock of a family farm or fishing corporation.⁸

Although legislative amendments were enacted in June 2021 to facilitate the transfer of a family business by an individual to the next generation(s) by providing an exception to the dividend deeming rules, where certain conditions were met, the government enacted further amendments to the rules in June 2024 to ensure the rules only permitted genuine intergenerational transfers of a business.

The latest changes impose new conditions that must be met both before and after the transfer, and are largely focused on both legal and factual control. A few examples of the conditions that must be met include:

• The transferor of the subject corporation shares (acquired by the purchaser corporation) must be an individual, the purchaser corporation must be controlled by one or more of the individual's adult children or grandchildren,⁹ and the subject corporation shares must also be QSBC shares or shares of the capital stock of a family farm or fishing corporation.
• The transfer of the family business may be done as either an “immediate” or “gradual” transfer. Under an immediate transfer, the transfer of the management of the subject corporation's business from the parent to the child or grandchild must generally be completed within 36 months of the transfer date. This period is extended to the later of 60 months and the final sale date for a gradual transfer.
• During the transitional period before management of the business has been transferred, at least one child or grandchild must remain actively engaged on a regular and continuous basis in the transferred business following the subject corporation share transfer and the business must be carried on as an active business.¹⁰

Several other conditions apply, as described in TaxMatters@EY, February 2024, “New rules for intergenerational business transfers.” A 10-year capital gains reserve may also be available for intergenerational share transfers that satisfy the relevant conditions.

These amendments apply to dispositions of shares that occur on or after January 1, 2024.

If you are considering selling your business to the next generation(s), consult with your tax advisor to learn more about how these rules might apply in your specific circumstances.

For more information, see Chapter 12, “Estate Planning,” in the latest edition of Managing Your Personal Taxes: a Canadian Perspective, EY Tax Alert 2021 Issue No. 25, EY Tax Alert 2022 Issue No. 23, and EY Tax Alert 2023 Issues No. 20, and 44.

Employee ownership trusts: An employee ownership trust is a new type of trust intended to give business owners an alternative succession option. Recent legislative amendments, effective January 1, 2024, give qualifying business owners the option of using an employee ownership trust to sell their business to employees. This type of trust is a form of employee ownership where a trust holds shares of a corporation for the benefit of the corporation’s employees. A key appeal is that it can be used to facilitate the purchase of a business by its employees without employees having to pay directly to acquire the shares. Several conditions must be met to set up and maintain an employee ownership trust.

Typically, the underlying business will loan funds to the trust, which then uses the funds to acquire a controlling interest in the business. The business is held in the trust for the benefit of employees, and the loan is repaid out of earnings generated by the business. These types of arrangements are used in the United States and the United Kingdom to support and encourage employee ownership of a business and facilitate the transition of privately owned businesses to employees.

The new rules include several measures to facilitate the use of employee ownership trusts in Canada. For example, recognizing that it can take time for the business to generate sufficient earnings to enable the trust to pay the purchase price for the business, a 10-year capital gains reserve is available in the case of a qualifying business transfer to an employee ownership trust.¹¹

The amendments also include a temporary exemption from taxation of the first $10,000,000 in capital gains realized on the sale of a business to an employee ownership trust, applicable to qualifying business transfers that occur between January 1, 2024 and December 31, 2026, subject to several conditions being met.

Draft legislative amendments released in August 2024 also provide for a similar temporary capital gains exemption and a 10-year capital gains reserve for qualifying sales of shares to a worker cooperative corporation that meets certain conditions, effective January 1, 2024.

In addition, the new rules exempt employee ownership trusts from the alternative minimum tax.

For more information, see EY Tax Alert 2023 Issue No. 47 and EY Tax Alert 2024 Issue No. 29.

Planning ahead: Have you considered whether you could benefit from the proposed new Canadian entrepreneurs’ incentive?

The 2024 federal budget and corresponding draft legislation introduced the Canadian entrepreneurs’ incentive. This new incentive will reduce the tax rate on capital gains from the disposition of qualifying property by eligible individuals, applicable to dispositions occurring on or after January 1, 2025.

Specifically, the incentive will provide eligible Canadian-resident individuals with a taxable income deduction that will effectively reduce the capital gains inclusion rate to one-third on up to $2,000,000 in eligible capital gains over an individual’s lifetime. The lifetime limit will be phased in by increments of $400,000 per year beginning on January 1, 2025, until it ultimately reaches $2,000,000 by 2029.

Qualifying property for purposes of this incentive includes QSBC shares, as well as qualified farm or fishing property, provided certain conditions are met.

In the case of shares, an eligible individual is required to have directly owned 5% or more of the issued and outstanding shares (having full voting rights) of the corporation throughout a period of at least 24 continuous months before the disposition. The individual must also have been actively engaged in the activities of the business on a regular, continuous and substantial basis throughout any combined three-year period since the founding of the business. The incentive will not apply to shares that represent a direct or indirect interest in certain excluded businesses.¹²

Eligible individuals will be able to claim the Canadian entrepreneurs’ incentive in addition to any available capital gains exemption. Therefore, if you are considering selling qualifying property that would be eligible for both this proposed incentive and the LCGE (see Increase in lifetime capital gains exemption above), consider waiting until after December 31, 2024 so you can benefit from both.

Note, however, that the LCGE must be claimed before claiming the proposed Canadian entrepreneurs’ incentive on any remaining taxable capital gain.¹³ You may not claim more than one of these deductions on the same portion of a particular taxable capital gain.

Conclusion

There are two benefits to doing year-end tax planning while there is enough time left in the year to do it well. First, you’re more likely to avoid surprises next April that can be both financially and emotionally stressful. Second, if done from the wide-angle perspective of comprehensive financial and estate planning (as discussed in Part 1 of “Asking better year-end tax planning questions”), year-end tax planning can help you understand whether you’re doing the right things in the right way, not just to minimize income taxes, but also to make it that much easier to achieve your longer-term financial goals.

The suggestions made in both Part 1 and Part 2 of “Asking better year-end tax planning questions” should help you set the agenda for a comprehensive discussion with your tax advisor this year and in years to come.

Tina Tai and Jeanne Posey, Vancouver

In Lewis v The King, the Tax Court of Canada was asked to determine whether the taxpayer made misrepresentations attributable to neglect on her 2012 and 2013 tax returns.

Under subparagraph 152(4)(a)(i) of the Income Tax Act (the Act), the Minister of National Revenue can reassess beyond the normal reassessment period if the taxpayer made misrepresentations that are attributable to carelessness, neglect or wilful default. The Minister alleged that the taxpayer made misrepresentations attributable to neglect in her 2012 and 2013 tax returns and, therefore, took the position that it could reassess the taxpayer beyond the normal reassessment period.

The Court focused on the meaning of “neglect” and whether the Crown met its burden to prove that the taxpayer’s actions constituted neglect.

Background and facts

The taxpayer was a retired personal support worker who felt she had insufficient tax knowledge to prepare her own tax returns, so she engaged a professional tax return preparer (LM). Around 2016, she learned that some of LM’s clients were involved in disputes with the Canada Revenue Agency, and stopped retaining LM as her tax preparer at that time.

LM prepared and submitted the taxpayer’s tax returns for 2012 and 2013. The returns were initially assessed on November 12, 2013 and November 10, 2014, respectively. On March 12, 2019, the Minister raised reassessments for the taxpayer’s 2012 and 2013 taxation years. The reassessments denied rental losses, employment expenses relating to the taxpayer’s use of a motor vehicle during her employment, and non-refundable tax credits in respect of charitable donations the taxpayer claimed.

At the hearing, the Minister conceded that the taxpayer did make the charitable donations she had claimed on her 2012 and 2013 tax returns. The CRA also conceded that the taxpayer did pay certain household expenses in respect of her rental expense claims for both years.

In cross-examination, the taxpayer revealed she did not review her 2012 and 2013 income tax returns before they were signed and submitted because she thought she would not understand them. Normally, these taxation years would be beyond the three-year normal reassessment period defined in subsection 152(3.1) of the Act, and were therefore statute barred. However, the Minister alleged that the 2012 and 2013 tax returns showed misrepresentations attributable to neglect because the taxpayer claimed disallowed rental expenses and motor vehicle expenses on these returns. As indicated above, subparagraph 152(4)(a)(i) allows the Minister to reassess statute-barred years if there is a misrepresentation attributable to carelessness, neglect or wilful default.

Issues

The central issue before the Court was whether the 2012 and 2013 reassessments were valid even though they were issued after the normal reassessment period had expired.

The CRA also brought up two additional issues:

• Whether the taxpayer was entitled to deduct motor vehicle expenses in her 2012 and 2013 taxation years
• Whether the taxpayer was entitled to deduct rental expenses for her 2012 and 2013 taxation years

Court’s analysis and decision

The Minister argued that the taxpayer had made a misrepresentation attributable to neglect by claiming rental expenses and motor vehicle expenses, and as a result the reassessments were valid even though they were made after the normal reassessment period. The Court noted that the onus was on the Minister to prove neglect in line with the case Deyab v Canada.¹

The 2012 and 2013 tax returns contained misrepresentations

The Court found that the taxpayer had made misrepresentations on the 2012 and 2013 tax returns. The 2012 return showed an amount claimed for renovations performed in the taxpayer’s basement. When questioned in cross-examination, the taxpayer stated that she did not provide LM with the amount of the deduction that was included on the return. Based on this information, the Court concluded that there was at least one misrepresentation in the 2012 return, and that the taxpayer would have recognized the amount as an incorrect statement if she had reviewed her return before it was submitted to the CRA.

Further, in both the 2012 and 2013 returns, the taxpayer claimed mileage expenses in connection with employment. The taxpayer admitted in cross-examination that she did not know the tax rules regarding motor vehicle expenses for employees and that LM himself had determined the mileage figure, because she did not know the actual mileage figures that related to the relevant activities. The 2012 and 2013 returns effectively stated that the taxpayer used her car solely for employment-related purposes. However, the Court found this “highly questionable” and reasoned that the taxpayer must have used her vehicle for personal purposes, at least in part, such as for purchasing groceries.

The misrepresentations were attributable to neglect

The Court noted that the term “neglect” in subparagraph 152(4)(a)(i) refers to a lack of reasonable care. The Court also followed Justice Sommerfeldt’s reasons in Gorev v The Queen, where he stated “a failure to review a tax return before signing it may constitute neglect or carelessness for the purposes of subparagraph 152(4)(a)(i).”²

In cross-examination, the taxpayer admitted that she signed her name on the tax returns without reviewing them. The Court found that this was neglectful, based on the clear jurisprudence, and that if the taxpayer had reviewed the returns she would have noticed the misrepresentations.

The Court concluded that the application of subparagraph 152(4)(a)(i) was triggered by misrepresentations that were attributable to the taxpayer’s neglect. The 2012 and 2013 years were therefore not statute barred and the Minister was allowed to issue reassessments for them. The two reassessments were referred back to the Minister for reconsideration and reassessment on the basis of the concessions the Minister made at the hearing with respect to property expenses and charitable donations.

Lessons learned

A taxpayer must exercise reasonable care by thoughtfully, deliberately and carefully reviewing their tax circumstances and filing a return they truly believe to be correct. Failure to carefully review returns and correct misrepresentations that ought to be found will likely allow statute-barred years to be open to reassessment. Although taxpayers do not have to be tax experts, they do need to exercise diligence and ask appropriate questions when reviewing the factual information included in their returns.

Courts have rightly held that subparagraph 152(4)(a)(i) is not a penal provision, but instead is intended to preserve the Minister’s right to reassess a taxpayer in circumstances where the taxpayer has not divulged all that they should have, or as accurately as they should have, and thereby has denied the Minister the opportunity to correctly assess all of the taxpayer’s liability under the Act in the first instance.³

The Court’s judgment in Lewis v The King was consistent with previous cases. To reassess statute-barred years, the CRA must prove that there were misrepresentations attributable to carelessness, neglect or wilful default. While the onus is on the Crown to prove that the taxpayer made such misrepresentations, the threshold of neglect may be met where a taxpayer fails to review a return prepared by a tax preparer.