Tax and estate-planning expert explains how COVID-19 could raise tax bills, and some strategies to soften the blow
The COVID-19 pandemic has had a massive and largely unpredictable impact on Canadians’ finances, with many households being able to save more and pay down their debt despite having reduced salaries or working hours. A major force driving that trend has been the widespread use of the Canada Emergency Response Benefit (CERB) which, coupled with a reduction in daily expenses, has effectively put more cash in some very lucky people’s hands.
Only they may not be so lucky. The saying “there’s no such thing as a free lunch” is arguably a cliché, but it’s a lesson that may come to haunt some Canadians expecting a business-as-usual tax season next year.
“There may be individuals who earn less income this year, but when they file their tax returns next year, will have more taxes owing to the CRA than they have in previous years when they had more income to report,” said John Natale, head of the Tax, Retirement and Estate Planning Services, Wealth team at Manulife.
Tax pitfalls from the pandemic
What people who’ve received CERB may not understand, Natale said, is that it counts toward the calculation of their taxable income. And unlike what they may typically expect with their monthly salary, the benefit payment they received is the gross amount they’re entitled to: the taxman couldn’t withhold the tax on that, but will be sure to collect what’s due in the spring.
“Now, that is changing. CERB is transitioning to three new benefits – the Canada Recovery Benefit, the Canada Recovery Sickness Benefit, and the Canada Recovery Caregiving Benefit,” he said. “The government is withholding 10 per cent of those payments, which obviously reduces the amount that the recipients are receiving, but will also reduce the potential tax payable to the government when they file their tax returns.”
There are other potential wrinkles for those who’ve shifted from payroll income to more government aid, he said. Unlike the usual situation where the employer withholds certain deductions and contributions – contributions to an RRSP, for example – and pays the government accordingly, Canadians counting on benefits are no longer getting those source deductions. And as far as Natale and his team can determine, CERB and its successor benefits don’t qualify as earned income for the purpose of generating RRSP contribution room, which means people who regularly maximize their contributions through automatic RRSP deposits might end up over-contributing without even knowing it.
“You might make a large contribution in your RRSP in the first 60 days or at some point in 2021, estimating that you have a similar amount of room as last year. But if you have less earned income this year and therefore less room, you may have overcontributed and be subject to an excess contribution tax as well as interest and penalties,” he said. “It’s very important to try to quantify what your earned income is, and what your RRSP contribution room will be going forward.”
Given the massive deficit spending path that the government is charting to keep the economy afloat, tax-planning professionals are tuning in to major announcements that could hold hints on tax policy. That includes the recent Throne Speech, which some have harshly described as “long on ambition and short on details.” One of its promises, a vow to “identify additional ways to tax extreme wealth inequality,” is something Natale acknowledged could be of concern. But aside from a reference to limiting the stock option deduction for wealthy individuals at large, established corporations, he said it didn’t drop enough details to back anything better than educated speculation.
“There are a lot of theories out there, and some of these theories have been around for a while,” he said. “One concerns a potential increase in the capital gains inclusion rate, which right now is at 50%; in the past, it’s gone up to two thirds and three quarters, then back down to 50%. There are also rumours about a potential wealth tax, and perhaps higher marginal tax rates – though I think that’s less likely because we’re already at extremely high rates historically – and possibly the loss of the principal residence exemption.”
Minimizing the tax bite
While Natale pegged the increase in the capital gains inclusion rate as the most likely development, he emphasized that it shouldn’t be the sole basis for any decision to realize a capital gain right now. However, there are other general guidelines that he said Canadians could follow as they try to minimize the pain from next year’s tax bite.
One best practice is for people to regularly check their CRA My Account and notices of assessment to identify any carry-forward amounts that they might be able to claim, like tuition, education expenses, moving expenses, charitable donations, and student loan interest. People may also want to look at any unused RRSP deductions they may have, and assess whether it’s worth using them for their 2020 tax returns; on a related note, they may also consider making an RRSP contribution and earn a corresponding deduction on their tax return, though he cautions that it will depend on their marginal tax rate for this year.
Another potentially useful strategy, particularly given how many investment portfolios have suffered this year, is to use the losses to offset any other capital gains within the year; any excess losses can be carried back three years or carried forward indefinitely. “Again, you don’t want the tax tail to wag the dog,” Natale said. “But if you want to realize the capital loss and you have other good reasons to do it, keep the settlement date in mind: if you do a capital-loss sale on December 30 or December 31, the settlement date will likely fall outside the calendar year since most investments take two days to settle.”
Investors looking to crystallize losses should also be careful to not trigger the superficial loss rules. Briefly, those rules specify that if an investor sells an asset for a loss, and buys an identical investment within 30 days before or 30 days after the sale, then still holds that identical investment 30 days after they sold their original investment, the loss will be denied and added to the cost base of the “replacement” investment.
While those rules are restrictive in most cases, Natale said they can be used to favour certain taxpayers with spouses. “Let’s say my investments are in a loss position, but I don’t have capital gains to offset them against, and my spouse has capital gains but no losses,” he said. “What I could do is sell my investments at a loss, immediately afterwards my spouse could buy the exact same amount of the identical investment, and then she continues to own it on the 30th day following my sale. That triggers the superficial loss rules for our benefit: my capital loss is denied, but it’s added to her adjusted cost base. Once she waits for 30 days to pass after my sale, she can sell the investment and be able to use the loss to offset her capital gains.”
Charitably inclined Canadians, he added, could make donations and get a tax credit; spouses can pool their contributions to help their favourite charity – which would likely appreciate the support at this time – and maximize the corresponding tax benefit. He also suggested that Canadians who have suddenly found themselves working from home may be eligible to claim certain work-from-home expenses, which would in part depend on how large their home office is relative to the total square footage of their home, by having their employer fill out a T-2200 form.
“I would encourage people to keep very copious notes – their tax slips, their records, and their statements, especially those relating to CERB – in case they’re subject to an audit or are asked to provide more information,” he said. “I’d also say people would be doing themselves a favour by preparing for their 2020 tax return early, with the help of a qualified advisor, so that they’re not caught scrambling with a large tax bill and having insufficient funds to pay for it.”