It’s no secret that Canadians pay a lot of tax. However, understanding how we’re taxed can help us minimize the tax we have to pay.
In Canada, we have a progressive tax system where individuals are taxed according to the level of their taxable income. As taxable income increases, we’re taxed at a higher rate, up to a point. Each increment of taxable income that’s taxed at a specific rate is referred to as a marginal tax bracket.
Tax rates vary by province and different types of income are included in taxable income at different rates. Salaries and professional income, for example, are fully taxed at your marginal tax rate, while Canadian dividend income and capital gains receive preferential tax treatment.
Understanding how your investment income is taxed
One of your considerations when buying investments should be the amount of taxes you‘ll pay on income from these investments.1 The types of income you could earn from your investments includes interest, dividends, capital gains and losses, and foreign income.
Interest income from Canadian sources is fully taxable at your marginal tax rate, making it one of the highest taxed types of income. Interest income is earned from bank accounts and from fixed-income investments, such as guaranteed interest accounts (GIAs), and government treasury bills (T-bills), as well as allocations or distributions received from segregated fund contracts, mutual funds, or exchange-traded funds (ETFs) that you own.
Dividends are distributions paid by corporations to their shareholders from after-tax earnings. You may also receive allocations or distributions of dividends from segregated fund contracts, mutual funds, or ETFs that you own if the funds own shares of Canadian corporations that pay dividends.
Compared to interest income, Canadian dividend income gets preferential tax treatment through the gross-up and dividend tax credit mechanism. The grossed-up amount is included on your tax return but the tax you pay is reduced by the dividend tax credit.
Dividends from Canadian corporations are reported as either eligible or non-eligible dividends. Eligible dividends are typically received from larger publicly traded corporations in Canada and are grossed up so that 138% of the dividend is included in taxable income. Non-eligible dividends generally would be received as a distribution of corporate income that has been taxed at lower corporate rates, such as income from a corporation entitled to the small business deduction. Non-eligible dividends are grossed up so that 115% of the dividend is included in income.
Because the grossed-up amount is reported on the tax return, it can be the least income-friendly for Canadians who qualify for valuable government benefits such as Old Age Security and the age credit.2 If the income reported on one’s tax return is too high, these benefits can be clawed back or forfeited altogether. For more information on how to reduce the clawback of these benefits, see “Fighting the clawbacks — reduce line 23400.”
Capital gains and losses
Capital gains arise when you sell a capital asset for more than its adjusted cost base (ACB). The increase in value is a capital gain, and 50% of the gain (called the taxable capital gain) is included in your taxable income. A capital loss arises when you sell a capital asset for less than its ACB.
Your ACB is the amount of your investment that has already been taxed. It begins as the original purchase price, but subsequent events such as purchases, allocations, distributions, or elections will impact your ACB. For further information see, “An investor’s adjusted cost base: a moving target.”
There are two types of capital gains and losses: realized and unrealized. An unrealized capital gain or loss consists of the accrued gain or loss on an asset before the asset is sold or deemed to be sold. A realized capital gain or capital loss generally results when the asset is actually sold or is deemed to be sold, as is the case on death.
Foreign income consists of income such as dividends and interest from foreign investments, whether owned directly or through a segregated fund contract, mutual fund, or ETF. Foreign income receives no special tax break, making it equivalent to interest from Canadian sources in terms of the high rate of tax that it attracts.
Interest income is usually taxable annually as earned, whether or not it’s actually received. Dividends are generally taxed when received. Capital gains, however, are taxable when realized. A realized capital loss must be applied against any capital gains realized that year and the excess, if any, can be used to reduce capital gains realized in any of the three preceding years or in any future year. This means that you can minimize your tax bill by taking into consideration the accrued gain or loss when deciding whether to realize a capital gain or loss.
Understanding the taxation of some common assets
So far, we’ve discussed how individuals are taxed, along with the taxation of certain types of income. Now, let’s discuss the taxation of specific types of assets that are owned in a non-registered account.
Mutual funds and ETFs
The difference between your ACB and the market value of your mutual fund or ETF units results in a capital gain or capital loss when the units are sold or deemed to be sold.
Distributions from a mutual fund trust or ETF are taxed according to the nature of the distribution (dividends, interest, capital gain, etc.). This distribution is taxable to you whether you receive the distribution in cash or it’s reinvested in additional units. If the reinvested amount is used to purchase additional units of the same fund, that amount is added to the ACB of your investment.
Mutual fund corporations pay dividends that can be either eligible dividends or capital gains. Dividends are taxable to you whether you receive the dividend in cash or reinvest it in additional shares of the mutual fund corporation. Reinvested dividends are added to the ACB of your investment and used to purchase additional shares of the same fund.
A common mistake for investors is forgetting to keep a record of reinvested mutual fund distributions or dividends. Reinvested distributions or dividends are added to the ACB, reducing the amount of any capital gain that arises when the fund is sold.
Return of capital (ROC) may also be reported as part of a distribution from a mutual fund or ETF. It represents a return of your original investment and results in a reduction of your ACB. If your ACB is positive, a distribution that’s identified as ROC is non-taxable. Once your ACB reaches zero (you’ve received the amount of your original investment back), all further distributions reported as ROC are taxable as capital gains.
Segregated fund contracts
Segregated fund contracts offer protective features only available through an insurance company, including death benefit and maturity guarantees, potential creditor protection, and the ability to bypass your estate. From a tax perspective, the difference between a segregated fund contract’s value and its ACB results in a capital gain or capital loss when sold. Allocations received from segregated fund contracts are taxed according to the nature of the allocation (dividends, interest, capital gain, capital loss, etc.). The amount of the allocation is reflected as an increase (or decrease in the case of a capital loss) to your ACB that is tracked by the insurance company. Furthermore, allocations can’t be paid in cash like ETFs and mutual fund distributions or dividends.
The difference between your ACB and the market value of your stock holdings results in a capital gain or capital loss when the stock is sold or deemed to be sold. Any dividends received from the stock are taxed at rates applicable to Canadian or foreign dividends.
Bonds that are actively traded in the market are taxed according to the type of return they generate. Since these bond investments are market traded, their value can rise and fall according to economic conditions. Consequently, as they’re bought and sold in your portfolio, capital gains or capital losses can result. Other income generated from these investments is taxed separately as interest.
GIAs and guaranteed investment certificates
Non-market-traded, fixed-income investments, like GIAs issued by insurance companies or guaranteed investment certificates issued by banks, are taxable only on the interest earned.
The importance of understanding basic tax aspects of investing
Because we pay so much tax, every precaution we can take to minimize tax counts. Investment taxation is an often overlooked but very important area of personal tax planning. Contact your advisor for more information about taxation and investment issues that concern you.
1 This article provides an overview of the taxation of personally owned non-registered investments. Income from registered plans is generally either fully taxable at your marginal tax rate when received (from deferred plans such as an RRSP, RRIF, RPP, or DPSP) or isn’t taxable (from a TFSA). 2 The gross-up together with the dividend tax credit means that eligible dividends are generally taxed more favourably at the personal level than non-eligible dividends. However, due to the higher grossed-up amount that’s included in taxable income, eligible dividends are more detrimental than non-eligible dividends in the calculation for income-tested benefits.
The commentary in this publication is for general information only and should not be considered investment or tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. Any amount that is allocated to a segregated fund is invested at the risk of the contractholder and may increase or decrease in value. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the fund facts as well as the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. The receipt of allocations from a segregated fund or distributions from a mutual fund is not guaranteed and may fluctuate. If distributions paid by the mutual fund are greater than the performance of the mutual fund, then your original investment will shrink. Allocations or distributions should not be confused with a fund’s performance, rate of return, or yield. You may also receive return of capital distributions from a mutual fund. Please consult with your tax advisor regarding the tax implications of receiving distributions. See the prospectus of the mutual funds, or the information folder and contract of the segregated funds, for more information on a fund’s allocation or distributions policy. Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.