International Appraisal of Effect of Capital Gains Tax on Investment in Small Business

Introduction and Evolution of Capital Gains Taxation One of the aims of the Federal government in Canada is to promote small business growth and expansion. An integral part of this process is the manner in which small business income is taxed, both on the income earned and the increase in value of company shares. An examination of the history of capital gains taxation in Canada is important to put the current day legislation in context. A capital gain in Canada is defined as the excess of proceeds over the adjusted cost base of a capital property that is sold. Capital property includes tangible assets such as land, buildings and equipment as well as shares, and intangible property such as trademarks and goodwill. If the proceeds are less than the adjusted cost base, a capital loss results. Prior to 1972, capital gains realized by taxpayers in Canada were tax-free. In 1971, a major tax reform introduced a tax on capital gains. At that time, capital gains were included in income at 50 per cent of the amount realized. For example, if a taxpayer realized a capital gain of $ 100, the amount taxable would be $50. This would be taxable at the marginal rate of the taxpayer. Capital losses could only be used to reduce capital gains and could be carried back three years and forward indefinitely to reduce future capital gains. In Canada, capital losses cannot reduce ordinary income. The Carter Commission in 1966 argued that exempting capital gains from taxation was contrary to the principle of neutrality. While the Carter Commission proposed to include capital gains in income in their entirety, the government chose to introduce a tax on capital gains by requiring the inclusion of 50 per cent of the capital gains. The reason for rejection of the Carter Commission recommendation was the negative motivational effect on investors1. The actual tax rate on capital gains changed as the tax rates in Canada changed over time however, the requirement to include 50 per cent of the gain remained unchanged until 1988. In 1988, new rules were introduced to phase in an increase in capital gains inclusion rates from 50 per cent to 75 per cent. This was phased in over two years with an increase to 66 2/3 per cent for 1988 and 1989 followed by an increase to 75 per cent effective in 1990. Another change to the taxation of capital gains in Canada was introduced in 1985 when a lifetime capital gains exemption was introduced in Canada as an attempt to promote the growth of small business. The total exemption of $500,000 was available to individuals to shelter the tax on capital gains on the disposition of certain capital property. The total exemption was subdivided between a $100,000 exemption on all capital property such as shares in public companies and real estate, and a $ 400,000 exemption on shares in qualifying small business corporations. The importance of the capital gains exemption cannot be underestimated. In the Province of Nova Scotia, for example, a taxpayer who has realized a capital gain of $500,000 on the sale of capital property eligible for the full $500,000 exemption for qualifying small business corporation shares would save approximately $60,000 income tax in 2001-2002. The savings in 1999 would have been a substantial $182,925. The reduction in 2001-2002 is a result of Federal Government regulations in 2000, which decreased the capital gains inclusion rate from 75 per cent down to 50 per cent effective for dispositions after October 17,2001. In the Budget of May 1985, which originally introduced the exemption, a loss of revenue to the government from allowing this exemption was estimated to be $300 million in fiscal 1986-1987 alone.2 Obviously, the utilization of this exemption is one of the few, yet sizeable, tax breaks left for small business owners in Canada. The taxation of capital gains remained in a steady state until rates were lowered both provincially and federally in 2001. Canada is divided into ten provinces and three territories. …

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