Last week, Canada’s Liberal government announced capital gains tax changes that, for the technology sector, have overshadowed all other items in Budget 2024.
In short, the Government of Canada has proposed raising not the tax rate but the inclusion rate on capital gains—which include profits from the sale of assets like stock or property—from one-half to two-thirds. Essentially, this means that a greater percentage of capital gains will soon be considered taxable income, potentially bumping some individuals and companies into new tax brackets.
By doing this, the feds hope to help finance billions in spending on housing and other priorities and increase tax fairness between middle-class and wealthy Canadians.
This move has prompted immediate and loud backlash from the country’s tech leaders. Many are angry, arguing these changes stand to stifle tech entrepreneurship and investment and exacerbate Canada’s existing productivity challenges. More than 1,900 Canadian tech leaders have already signed an open letter calling on the feds to reconsider. Doctors and other groups, including professionals with retirement nest eggs and folks with estate plans and rental properties, will also be affected.
RELATED: Capital gains tax changes strike a nerve with Canadian tech ecosystem
Meanwhile, other leaders across the tech sector—some openly, some quietly—have argued this reaction is overblown, noting that while tax outcomes are a consideration, tech founders do not decide to start businesses because of them and typically make location decisions based on other factors first. Many have also pointed out that Canada’s inclusion rate was previously 75 percent in the 1990s when the country also saw a jump in productivity.
As these proposed changes stand to have a significant impact on Canada’s tech sector, BetaKit thought it worthy to take a deep dive to explain what they are and what they might mean for various industry stakeholders once they begin to come into effect on June 25 of this year.
Index
- Raising the inclusion rate on capital gains
- Increasing the Lifetime Capital Gains Exemption (LCGE)
- Launching the Canadian Entrepreneurs’ Incentive (CEI)
- What is not changing about capital gains taxes
- General impact
- Impact on tech entrepreneurs
- Impact on tech investors (VCs and angels)
- Impact on tech workers
- Impact on tech companies
How capital gains taxes are changing
Raising the inclusion rate on capital gains
For individuals, companies, and trusts, the inclusion rate on capital gains, or the proportion considered income for tax purposes for the year that an asset was sold, is being raised from half (50 percent) to two-thirds (67 percent).
For individuals, this increase will apply only to capital gains realized annually beyond $250,000 CAD. The first $250,000 will continue to have a 50 percent inclusion rate. For companies and trusts, this inclusion rate hike from half to two-thirds will apply to all realized capital gains.
To offset the impact of this hike on entrepreneurs in tech and other sectors, the feds are also proposing the two other capital gains tax changes outlined below.
Increasing the Lifetime Capital Gains Exemption (LCGE)
The cumulative Lifetime Capital Gains Exemption (LCGE) is being increased from just over $1 million to $1.25 million. Going forward, the LCGE will continue to be indexed to inflation.
The LCGE is a longstanding tax exemption designed in part to help encourage risk-taking among small business owners. It enables entrepreneurs to claim deductions to their taxable income for capital gains when they sell qualified small business shares they have held for at least two years in Canadian-controlled private corporations (CCPCs). To be a CCPC, a company must be privately held with an aggregate of shareholders that is more than 50 percent Canadian.
Launching the Canadian Entrepreneurs’ Incentive (CEI)
A new Canadian Entrepreneurs’ Incentive (CEI) is being launched to reduce the inclusion rate to 33.3 percent on a lifetime maximum of $2 million in eligible capital gains. According to the Government of Canada, this incentive was designed with the tech sector in mind and modelled after the qualified small business stock exemption in the United States (US).
The CEI will be available to entrepreneurs and founding investors in certain sectors who own at least 10 percent of shares in a business that has been their principal employment for at least five years. The feds plan to phase in the CEI gradually over the next 10 years by $200,000 annually, beginning in 2025, until it reaches $2 million in 2034.
What is not changing about capital gains taxes
Tax treatment of capital losses from previous years, which can be used to offset capital gains in future years, will remain the same. The feds also plan to maintain the exemption for capital gains from the sale of a principal residence.
The impact of these capital gains tax changes
According to the Government of Canada, once the CEI is fully rolled out, the CEI plus the enhanced LCGE will give Canadian entrepreneurs at least $3.25 million in total and partial exemptions when selling all or part of their businesses. The feds have claimed that tech entrepreneurs with eligible capital gains of up to $6.25 million will be better off following these changes than they were under the previous system, while above this amount, they will owe more in taxes than they did before.
Next year, the Government of Canada predicts that these proposed capital gains tax changes will impact 0.13 percent of the population (40,000 people), and 12.6 percent of Canadian businesses (307,000 companies). It estimates the changes will generate $19.4 billion in revenue over the next five years.
On LinkedIn, Koho founder and CEO Daniel Eberhard believes the framing that this will impact 0.13 percent of the richest Canadians is “disingenuous,” noting that they will instead hit 0.13 of the biggest tax events in a given year.
The feds claim tech founders with up to $6.25 million in eligible capital gains will be pay less with these changes while those with more will pay more.
The Government of Canada says that these moves, coupled with other tech-related measures in Budget 2024, offset each other and improve conditions for the Canadian tech sector on a net basis, but many industry leaders beg to differ.
The full implications of them remain unclear. Here is what we know so far about what these proposed changes mean and how they might affect stakeholders across the tech sector.
Selling a business is “oftentimes a once-in-a-lifetime opportunity for folks to realize the fruits of their labours over many, many years,” Deloitte tax partner Rob Jeffery told BetaKit in an interview. Speaking to the impact of these capital gains tax adjustments, Jeffery noted, “Any transaction, with these changes, just got far, far more expensive.”
Jeffery added that the $250,000 threshold for individuals matters less for Canadian tech entrepreneurs who sell their businesses for tens of millions of dollars than for smaller investors and entrepreneurs who end up selling firms for much smaller amounts. He said that the LCGE increase, by nearly $250,000, is “not a massive change.”
The Deloitte tax partner anticipates that the CEI will have a more pronounced effect on the country’s tech founders over the long run, but noted that it will take a while to have any big impact, given the fact that it will be rolled out over the next 10 years.
As the holding periods for LCGE and CEI are different—two versus five years, respectively—some sales of tech companies may qualify for the LCGE but not the CEI.
The rates at which capital gains are taxed vary a bit based on province for both individuals and companies. For entrepreneurs, investors, or employees who have sold shares of a tech company and earned $200,000 in capital gains in a given year, there will be no change in how that amount is taxed. For individuals with more than $250,000, and tech companies themselves, it is a different story. Here is what that impact might look like under these new tax rules.
Impact on tech entrepreneurs
As previously noted, these capital gains tax changes will impact Canadian tech entrepreneurs, with some variation based on the province of residence.
Using an individual in Ontario with an annual income of more than $250,000 as an illustration, Jeffery noted that with this inclusion rate hike, most sales of shares will now be subject to a tax rate of approximately 36 percent, or about a nine percentage point increase relative to under the previous rules. A tangible example, he said, would be that in most cases, on every million dollars worth of capital gains that a given Ontario tech entrepreneur realizes when they sell their startup, they would be expected to pay an additional $90,000 or so in taxes.
He acknowledged that CEI also stands to change the equation a bit for tech founders. Through CEI, Jeffery said, come 2034, their first $2 million of capital gains will only be subject to a tax rate of about 18 percent, with a tax rate of about 36 percent on any additional capital gains. Contrast that with today, when entrepreneurs pay no tax on their first $1 million in capital gains and 50 percent on all profits beyond that.
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Budget 2024 offered one specific example to illustrate how together, these changes might positively impact the tax burden of a tech entrepreneur—in this case, a hypothetical FinTech founder named Kate who launched her startup several years ago and has decided to sell it to a larger FinTech firm that plans to use its resources to scale her company’s tech.
This acquisition nets Kate $2 million worth of capital gains. Since she already maxed out her $1.25-million LCGE when she sold some shares to a business partner, under the current system, she would pay tax on $1 million, or 50 percent of that $2 million in capital gains. Were Kate to sell her company in 2034 once CEI is fully available, she would pay tax on only $667,000, or one-third of her $2 million. In short, the CEI would reduce Kate’s taxable income by $333,000, as compared to right now.
Extending this example, if Kate’s co-founder Mohamed, who joined the FinTech startup less than five years previously, also received $2 million in capital gains from the 2034 sale and previously exhausted his LCGE, he would not have access to the CEI at all and would pay taxes on half of that first $250,000 and two-thirds of his remaining capital gains, for a total of about $1.29 million, more than the $1 million in taxable income he would have under the current system.
The federal government plans to roll out the CEI very gradually. So, if Kate was to sell her startup later this year, she would not be able to take advantage of the CEI at all. Of her $2 million in capital gains, she would have to pay taxes on about $1.29 million—$290,000 more than through the existing tax structure.
Quick summary of the above examples:
- A) Kate exits today for $2M (no LCGE or CEI) = $1M taxable income
- B) Kate exits in 2034 for $2M (no LCGE but full CEI) = $667K taxable income
- C) Mohamed exits in 2034 for $2M (no LCGE or CEI) = $1.29M taxable income
- D) Kate exits post-June 25, 2024 for $2M (no LCGE or CEI) = $1.29M taxable income
Former Shopify vice-president of product and Ramen Ventures founding partner Adam McNamara noted on X (formerly Twitter) that the CCPC requirement already excludes many Canadian tech startups because they have taken funding from US venture capital (VC) firms due to a lack of local VC funding or quality investors. After two financing rounds led by US VCs, companies might not qualify for LCGE, he added.
Had Kate’s Canadian FinTech startup raised too much from American VCs before the sale, she would still have access to the $250,000 threshold and CEI, but would no longer be able to take advantage of the LCGE.
Jeffery noted that in his experience, some companies that have taken foreign money have business activities where entrepreneurs have already taken steps to utilize their LCGE.
Impact on tech investors (VCs and angels)
These changes also stand to impact Canadian investors, including venture capital (VC) funds and the limited partners (LPs) that back them when it comes to the tax they pay on capital gains realized when they sell their shares in the companies they have invested in.
CMD Capital partner Matt Roberts recently told the BetaKit Podcast he believes that they could depress capital availability for VC funds and investor willingness to back tech firms. Per Roberts, the majority of angel investors invest through corporations, sometimes trusts, while most VC fund LPs invest through corporations (typically only a small proportion are direct individuals).
“Increasing the tax there automatically affects the calculus of what it takes to return capital … As they pay more tax on the returns, it makes it more difficult—they have to see a higher return from the VC side of the equation or it makes less sense,” said Roberts.
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As Roberts noted, many LPs recycle capital to invest in VC funds, meaning that as those funds return capital following exits, some of those LPs invest some of that money back into those funds. “If the government is taking a bigger slice on that mechanism when I go back and ask them for money, there’s less money to ask for on my end,” he added.
Bidali co-founder and Bullish Ventures managing partner Eric Kryski said on X that at a time when high interest rates are already dampening VC commitments, these changes make “the bar for a good risk-adjusted return even higher.” He added that successful tech founders tend to become angels and back the next wave of entrepreneurs. He believes they “likely [mean], of the successful founders that do make it, less [Canadian] angel money.”
The National Angel Capital Organization (NACO) has echoed concerns that these changes will lead to a pullback from angel investors who back very early-stage tech startups. Haloo founder and CEO Julie MacDonell told BetaKit that, “if this prediction is correct, it could have dire consequences for women and underrepresented entrepreneurs who, due to barriers in traditional financing, rely disproportionately on angel investment to start and grow their businesses.”
Impact on tech workers
In Canada’s tech sector, much wealth is created through stock options. Jeffery noted that these proposed capital gains tax changes will also apply to tech workers with stock options, and impact folks who have realized more than $250,000 in stock option benefits in a given year, which are taxed equivalent to capital gains.
Employees at tech startups are typically paid in a combination of cash and stock options, the latter of which help companies lure talent from other firms, sectors, or countries and retain them. Those employees often forego some cash in the short term on the bet that their equity stake in these tech startups will become much more valuable down the road. Though most fail, for those who succeed, the payoff can be particularly lucrative.
These changes stand to make exercising those stock options more expensive. Should an employee do so, the difference between the strike price of that stock option and the market value of the share used to acquire it counts towards that $250,000 threshold. Essentially, if an employee redeems stock options and profits—even if just on paper—this is taxed as if it is a capital gain. In short, tech workers with more than $250,000 in capital gains in a year from exercising stock options and other means will pay more in taxes under the new system.
“It’s already really hard for companies to actually actualize the stock options that you do, and now if you get to the end of that journey, they’re going to be worth even less,” Bergen told the BetaKit Podcast.
Bergen predicted the changes would make it tougher for innovative companies to hire and retain employees. “The calculation that folks are now taking is one in which the reward doesn’t match the risk,” he argued.
Impact on tech companies
Under Canada’s tax system, stock options in CCPCs, including tech startups, provide additional flexibility versus non-CCPCs, including publicly traded or foreign-owned tech firms.
With these proposed capital gains tax changes, Jeffery noted that stock options in CCPCs will be more heavily impacted than stock options in public or foreign-owned companies over a certain amount, given changes Canada made a few years ago to how the latter are taxed.
Corporate tax rates also have some variation based on the province of residence. Today in Ontario, Jeffery noted that CCPC capital gains income is taxed at a rate of about 25 percent at the current 50 percent inclusion rate. After June 25, they will rise to about 33 percent.
In Ontario, public or foreign-owned firms are currently taxed at a rate of about 13 percent. Under the new rules, Jeffery noted that they will pay about 18 percent. Per Jeffery, public companies pay less tax on capital gains because those Canadian shareholders pay more tax when the profits are distributed. When capital gains are fully distributed to shareholders, there is little difference in the combined tax burden for Canadian shareholders between a public or foreign-owned firm when compared to a CCPC.
With files from Bianca Bharti and Douglas Soltys.
Image created by Meagan Simpson.
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Originally published on BetaKit : Original article