Not All Taxes Are Created Equal

Last updated October 7th 2023

 

Disclaimer: The information in this article is not intended to provide tax advice. To ensure that your own circumstances have been adequately considered and that action is taken based on the latest information available, you should speak with a qualified tax advisor before acting on any of the information in this article.

 

Brief Intro

Nobody likes them but everybody has to pay them. Taxes are the primary revenue source for governments and your investments are not safe from the tax man. As boring as it sounds it is important to understand the different taxation policies because they can make a significant difference in your final return as we will demonstrate with an example at the end.

We’re going to discuss tax on interest income, dividends, capital gains, and a quick note on foreign income. This article will assist you in analyzing one (of many) considerations when it comes to investing. Read on.

 

Interest

How much you get dinged on interest income is the simplest to calculate however it is the least friendly. For the majority of taxpayers, interest income will be generated from savings accounts, Guaranteed Investment Certificates (GICs), and bonds. It’s important to be aware that all interest income, no matter how small the amount, is taxable, and must be reported on your tax return.

Typically financial institutions will only issue a T5 if the interest earned is over $50 and therefore some people may think they don’t have to claim interest below $50. Unfortunately that’s not true, any amount of interest payable must be reported.

Here’s one more thing: even if you don’t actually receive the interest you still must report what has accrued on your income tax. Some investments like GICs and bonds with terms greater than one year will compound interest (this is good because it’s interest on top of interest) but won’t actually pay it out until maturity. Let’s walk through an example

At the beginning of the year, 2023, you buy a $10,000, three year GIC that pays interest at a rate of 4% per year, compounded annually, with all interest paid at maturity. On your 2023 tax return, due at the end of April 2024, you must report and pay tax on $400 of interest income (4% of $10,000), even though you have not actually received any interest from the GIC issuer.

The tax rate at which you pay interest income is your marginal rate, whatever that is. There are no beneficial credits or inclusion rates to save you, as there are with upcoming investment returns which is why interest is the least efficient.

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Dividends

We’re going to keep this fairly high level but give you enough information to have a solid understanding of two different types of dividends and the different tax rates. Please note, this discussion applies to Canadian companies paying dividends to Canadian residences.

When paying a regular dividend Canadian corporations can pay both eligible or non-eligible dividends. The ability to make such a determination depends mostly on a corporation’s status. Since 2006, dividends paid by a Canadian public corporation (companies that trade on a stock exchange) are typically classified as eligible dividends.

On the other hand, a Canadian Controlled Private Corporation (CCPC)  can pay both eligible and non-eligible dividends. 

For the purpose of this article we will keep things simple and not go into the details of how a dividend is designated eligible or non-eligible. They will be clearly stated on your T5.

Because dividend income is already taxed by the corporation before being distributed to shareholders, the tax rate is lower than that of other income such as employment income, rental income or interest income.

Eligible dividends are subject to an enhanced dividend gross-up. They are grossed up by 38% of the received amount in order to reflect the corporate income that was earned. Individuals who earn eligible dividends can claim a federal dividend tax credit. The federal dividend tax rate on eligible dividends is 15.0198%. There is also a provincial or territorial dividend tax credit available, which differs for each province or territory so consult with a local tax professional for more details. 

Non-eligible dividends are subject to a dividend gross-up that is smaller than the eligible dividends. The gross-up for non-eligible dividends are at a rate of 15% to reflect the pre-tax income. Since the gross-up is smaller so to is the federal tax rate of non-eligible dividends set at 9.0301%. Similar to eligible dividends, you are also eligible for a provincial or territorial dividend tax credit. 

Keep in mind though, that in order to receive the federal dividend tax credit, the dividend has to come from Canadian corporations and be paid to Canadian individuals, along with meeting the tax criteria. The reason the dividend tax credit is issued is to avoid double taxation since the Canadian corporation that issued the dividend already paid taxes on the income they received.

 

Capital Gains

When you own capital that has appreciated in value and then sell it, you owe the Canada Revenue Agency money. There are several types of capital property that incur capital gains when you sell them. Common ones include:

• Stocks and bonds
• Mutual funds
• Rental properties
• Land
• Buildings
• Rare antiques
• Vacation properties
• Business equipment

Unlike interest where you are required to claim taxable income even if you don’t receive it, with capital gains you are not taxed until you realize the sale. If you dispose of capital in 2023 you will be required to report the gain in April 2024. 

Let’s say you have a rental property you purchased for $500,000. For this scenario we’re going to ignore transaction costs. In a few years the property is worth $600,000 and you cash in. You now have a $100,000 capital gain. 

Thanks to the beneficial inclusion rate only 50% the gain is taxable. So you need to include $50,000 as additional income for the year. The rate at which you pay is your marginal tax rate. Generally when you sell property it will bump you up a couple brackets so lets say you’re at a 45% marginal rate. The tax payable is calculated as $50,000 x 0.45 = $22,500.

In real terms the total tax rate you are paying from the sale is 22.5% . You gained $100,000 and you paid $22,500 therefore $22,500 / $100,00 is 22.5.

Now nobody ever celebrates when their investments are at a loss but there is a silver lining. Just like you get taxed on a capital gain, if you realize a capital loss you can deduct that against other capital gains. The nice part about this deduction is there is flexibility for when you use it. You may apply the loss three years backwards or carry the loss forward indefinitely.  If you realize $5,000 in capital gains but also had $1,000 in capital losses you can deduct the $1,000 to now have taxable income of $2,000 (5,000 – 1,000 = 4,000 x 50%).

To make your life easier, it’s worth keeping documents pertaining to the purchase and sale of the investment You’ll need to keep record of details such as:

• When you purchased it
• How much you bought it for
• Any costs you incurred to buy the capital or maintain it
• The adjusted cost base (ACB)  which is the cost of a property plus any expenses you paid to acquire it, such as commissions and legal fees, plus any additions or upgrades made to property.

Having your documents in order will be a life saver when it’s time to file. It’s recommended to keep all your documents for at least 7 years because the CRA can audit you at any time.

 

Foreign Income

To go into the details of taxable foreign income is beyond the scope of this article. Just know that Canadians are taxed on their worldwide income, meaning any assets you own outside of Canada are taxable to CRA. Not fun right? There are foreign tax credits and tax treaties between countries but if you think this may affect you talk to a tax professional about your situation.

 

Investment Example

Alright so we’ve gone through the three main ways you’ll be taxed on your investments. So here’s a mathematical example of why you should care. Let’s pretend our friend Serpent Stan has $10,000 to invest. Serpent Stan can invest in a GIC, a dividend paying stock, or a stock that does not pay a dividend but is meant to appreciate over time.

If Stan buys a 1 year GIC the interest will be 5%. Therefore Stan will earn $500 worth of interest. Stan’s marginal tax rate is 35% so Stan must pay $500 X 0.35 which is $175 in taxable income. The net return is now $500 – $175 which is $325 in Stan’s pocket.

Serpent Stan also could choose to buy a dividend paying stock. Stan buys $10,000 of shares in SSS Corp. The company pays a 5% dividend yield. After a year the stock has not appreciated at all but did pay out $500 in dividends so our friend sells the stock.

Remember the dividends are grossed-up by 38%  which comes to $500 X 1.38  =$690. Stan’s federal credit is 15% of $690 = $103. Stan can also claim a Provincial tax credit but we will leave it out for simplicity. Stan reports $690 in taxable income at marginal rate of 35% Stan will pay $241.50 before the federal credit is applied.  Once we apply the credit of $103 Stan’s final amount owed is $138.50. All this leads to Stan netting $361.50 calculated as $500 from the dividends minus $138.50 in the final tax liability.

In the last scenario Stan actually chooses to buy a stock that does not pay a dividend but has prospects for growth. Our slithery investor buys SRP Inc for $10,000. Wouldn’t you know it after one year the stock has increased 5% in value. Stan once again has a $500 gain but this time it’s strictly capital gains. As a reminder only 50% of the capital gains is taxable so Stan keeps $250 for free and is taxed at 35% on $250. Serpent Stan has to pay $87.50 in taxes taking his net gain to $412.50

 

Summary

Let’s summarize the final investment results

 

 

 

 

 

 

 

 

 

 

 

As you can see, how you are taxed greatly affects your final rate of return. Taxes are not the only consideration when making an investment. Factors like time horizon, risk tolerance, personal beliefs, geography, current holdings, etc. all need to be taken in with the decision. 

If you’re looking to refine your investment game check out our guide How To Start Investing to ensure you have a solid foundation.